Opportunities amid uncertainty: Structured Notes

December 2, 20226 min read
Opportunities amid uncertainty: Structured Notes
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We launched our structured notes program to help members gain access to a financial tool historically only available to institutional investors. Due to a high minimum barrier, retail investors simply didn’t have the capital to take advantage of the hybrid security before, so called because it combines features of multiple different financial products into one.

Structured notes can come in the form of income notes. They track the value of another product, which means the return on them depends on the issuer repaying the full principal of the investment, in addition to the premium of the underlying asset. 

We began offering income notes on the platform in May of 2021. They’ve grown in popularity since then, especially amid the tighter monetary policy, rising inflation, and geopolitical instability affecting public markets. While we acknowledge that the wider markets suffering large, historic losses may affect some of our notes maturing in the next few months, we are still anticipating a better performance than public markets for a few key reasons.

For one thing, our offering can potentially generate higher income than traditional fixed income products, because of the meticulous selection process for the underlying assets. Moreover, the notes offer some downside protection during broader market turbulence, which can allow investors to potentially gain from higher coupon payments in times of heightened volatility. And last, Yieldstreet prides itself on its thorough due diligence when selecting the underlying assets, relying on data heavy models to help choose optimal company names. 

Market summary

Soaring inflation and rising rates

The Federal Reserve continues to increase interest rates, while signaling that they won’t shy away from raising interest rates to larger-than-expected levels to combat high inflation. Though consumer prices remain elevated at 7.7% as of October’s CPI data, it was the first significant drop from the 8.2% the month before. 

Projected CPI data for December shows early signs of inflation cooling1, but the verdict is still out on when we’ll see the last of interest rate hikes. At the same time, low unemployment and supply chain issues may keep fueling inflation.2 Experts believe prices will remain elevated for some time and that true CPI results come with a time lag, which might mean the Fed will continue to raise interest rates well into the beginning of next year. 

Credit spreads widening

The difference between the yield of a corporate bond and treasury bond often acts as a proxy for economic health. Narrowing credit spreads usually signal improving economic conditions, while widening credit spread can potentially mean worsening economic conditions. Currently credit spreads have widened, reflecting investor sentiment that there will likely be an uptick in company defaults, which is indicative of an overall pessimistic outlook on economic conditions.3

Tech sell-off and layoffs 

During the COVID-19 pandemic, many technology companies experienced a surge in demand, resulting in over-hiring. Today, amid the increased interest rates, the need for discretionary spending in tech has fizzled, trickling down to tech companies’ earnings. This signals that tech companies are finding it harder to grow amid the current market environment as revenue streams slow. As a result, tech stocks have fallen over 30%+ this year, leading to major tech companies, including Meta and Amazon, announcing layoffs and hiring freezes due to the slow down in growth.4

War in Ukraine

Though the Russia-Ukraine War is more of a tail-risk event for the US, a resolution can either cause the market to rally or fall. Additionally, Russia’s invasion of Ukraine has impacted global economies primarily through the rise in energy and agriculture prices. Sanctions imposed on Russia have caused countries such as Europe, which depend on Russia to supply ⅓ of its natural gas, to find alternative suppliers and store natural gas in preparation for this winter and future winters.5 Fear of a shortage of natural gas looms, and if Europe’s economy slows because of its energy reliance this winter, it could impact companies in the US that do business in the EU.

Structured notes amid the volatility

The underlying stocks backing our structured notes are well diversified, offering investors a way to mitigate some of the loss from the volatility.

Diversification across vintages

Because returns for structured notes depend on the underlying stocks being above a certain barrier level, investing across different strike dates, strike prices and maturities can help mitigate risk of loss.

Diversification by strike date and strike price is critical – especially in bear markets when stock prices are expected to continue to slide – because it reduces the average strike price of the product, as well as the barrier at which the investor is paid the coupon and the principal. 

Moreover, the return on an income note depends on the price of the underlying stock when the note matures. Therefore, to further limit the market timing risk, investors may want to consider diversifying across multiple vintages. Yieldstreet typically launches a new portfolio of income notes every two weeks, allowing investors to add another level of diversification. 

Diversification across industries

We also believe it’s essential to diversify across industries. In 2019, big tech was one of the best performing asset classes in the public markets. Now, performance for names like Meta, Netflix, and Amazon is down down 40-70% year-to-date.6 An investor’s portfolio heavily concentrated in tech names would be heavily impacted in this environment, but a portfolio with diverse exposure to other industries, such as energy consumer staples and financials, is expected to better withstand volatile market conditions. 

Diversification across names

Our income notes portfolios consist of three notes – all tied to a different underlying stock –  but this can only help to diversify a portfolio so far. Investing in other structured note portfolios can allow investors to diversify across other public market names. 

An average diversified stock portfolio consists of 20 to 30 stocks7 but studies show portfolios containing 12 – 18 stocks provide about 90% of the maximum benefit of diversification.8  Investors should consider investing in at least four to six structured note portfolios to achieve optimal diversification across different names.

While the current market landscape is challenging, income notes stand to potentially benefit from the volatility. 

In the current market environment, investors have the opportunity to invest in income notes with some downside protection and higher coupons. Moreover, they can benefit from where public markets are currently trading. In other words, because structured notes depend on the underlying security being above a certain downside barrier level in relation to its strike price, public markets trading at lower levels makes the likelihood of the security breaching its barrier value slimmer.

Income notes also continue to generate regular quarterly coupon payments as long as the notes are above their downside protection barrier. Our recent launches, for example, have provided investors with access to 9-month offerings at target annualized returns of over 10%. 

Because we launch income notes portfolios on a regular basis, investors can build a customized position that’s well diversified across theme and maturity. Recently, we’ve also been focused on launching shorter duration 9-month maturity structured notes, which is attractive in a risk-off market environment for their higher yields and easy convertibility to cash.

Our structured notes team at Yieldstreet prides itself on its thorough diligence process.

During this market environment, we’re especially focused on choosing companies that are capable of withholding a downturn, which means we gravitate toward names that are large, high quality and stable. Moreover, we rely on our own extensive market research when screening for company names, which consists of quantitative models and regression analyses conducted by some of the top experts in the industry.

1 https://www.cnet.com/personal-finance/banking/will-the-fed-raise-rates-again-in-december-what-the-latest-inflation-data-tells-us/
2 https://time.com/nextadvisor/investing/expert-say-how-long-will-take-inflation-to-come-down/
3 https://www.investopedia.com/ask/answers/022615/what-types-financial-situations-would-credit-spread-risk-be-applied-instead-default-risk.asp#:~:text=Credit%20spreads%20are%20the%20difference,therefore%2C%20is%20higher%20interest%20income.
4  https://time.com/6226927/tech-stocks-slump-economy-forecast/  
5 https://www.usbank.com/investing/financial-perspectives/market-news/russia-ukraine-global-market.html
6 https://www.forbes.com/sites/dereksaul/2022/10/28/heres-how-big-tech-stocks-have-performed-in-2022-as-faang-softens-its-bite/?sh=2856999812db
7 https://www.businessinsider.com/personal-finance/how-many-stocks-should-i-own
8 https://www.forbes.com/sites/forbesfinancecouncil/2021/09/08/the-diminishing-benefits-of-too-much-stock-diversification/?sh=4304c8865d07