Stocks enter bear market, but structured notes could offer silver lining, analysts say

By Emma Trincal

New York, June 15 – In the worst week for stocks since January, investors in structured notes continued to bid on equities, the top asset class in the industry. Structured notes may benefit from a flight to safety, analysts said.

Total sales of structured products for the past week amounted to $357 million in 101 deals. Equity-linked notes accounted for $206 million in 87 offerings, according to data compiled by Prospect News. The 57.75% market share was apparently small compared to 87% on average for the year to date.

But an exceptionally large rate-linked note offering of $112.89 million skewed the data.

Taking this trade out of the total, equity-linked notes made for nearly 85% of total sales.

With volatility building up on the week preceding the Federal Open Market Committee meeting, the market dropped sharply on Friday on the release of CPI figures showing inflation hitting a 40-year high. The Dow Jones industrial average dropped 800 points on the day. For the week, the Dow lost 4.6% and the S&P 500 index shed 5.1%.

Issuance volume of structured notes for the year through Friday is down 14% to $37 billion from $43.37 billion a year ago, the data showed. The deal count dropped significantly to 7,480 from 13,097, a 43% decline. Big-size deals in excess of $50 million were fewer: 50 last year compared to 40 this year.

CPI shock

Friday’s equity sell-off turned worse with the release of the June University of Michigan consumer sentiment index showing its lowest point since the late 1940s. Anxiety over the upcoming Federal Reserve meeting amplified the turmoil.

“The stock market reacted so strongly because it’s shaking out this irrational euphoria seen in bonds, stocks and crypto,” said Ed Easterling, president of Crestmont Research.

“We were so misaligned. The Fed has been distorting market rates, driving an upbeat market sentiment for a long time. We’re now going through a painful realignment.”

“In addition to that, investors realize that inflation is persistent and that the Fed needs to hike rates aggressively. At first the patient didn’t want to take the pills. But the patient is not getting better. Ultimately the pills will be desired because they provide the better outcome.”

He spoke ahead of the Fed announcing a 75 basis points rate hike on Wednesday.

Bear market is official

The S&P 500 officially entered a bear market that began on Jan. 3, announced Howard Silverblatt, senior index analyst at S&P Dow Jones Indices.

The index closed 20% below its January high on June 13.

“We hope it will be short, maybe 18 months or a little bit more. As of today, it’s only five months,” Silverblatt told Prospect News.

“Some can be very short. The bear market of 2020 was the shortest one on record but a pretty severe one driven by one event. The pandemic led to a massive shutdown of the economy, a significant decline in spending and employment. Then came a massive stimulus, which sped up the recovery.

“We think that this bear market may be shorter than average. The economy is still good. Employment is still high.”

Silverblatt offered a relatively optimistic outlook on how the bear market may impact structured notes.

“In a bear market, you typically see a flight to quality. When you sell your ETFs, where do you go? People who are dumping their stocks want instruments that provide safety. Structured notes are one example among many. You’ll also see people putting money into shorter government bonds and money markets,” he said.

Volatility and liquidity

The VIX index began the week at 25 and ended up close to 35, a 40% jump in just five trading days.

“This is volatility, folks. It moves in both directions. It overshoots in both directions,” said Steve Sosnick, Interactive Brokers’ chief strategist.

One condition for a healthy structured notes market is a high level of liquidity. It gives issuers the ability to optimize pricing and better hedge their positions.

“The price moves are a little bit more magnified because liquidity tends to be lower when markets are volatile,” said Sosnick.

“Market makers don’t provide the same type of liquidity that they do when the markets aren’t moving.

“Each trade they do is riskier. They compensate by shrinking their sizes or widening their spreads.”

Fortunately, the current sell-off has not posed real liquidity risks so far, said Easterling.

“We have this cross current right now, which creates a lot of volatility,” he said.

“Volatility is the nemesis of liquidity. Being liquid requires stability and trust. And we’re getting into a period of increased uncertainty with the mid-term Elections, the soaring inflation, and the risk of a recession. So far, the market has done pretty well in terms of liquidity.”

Choppy waters

Sell-offs can present opportunities to long-term investors, the analyst said.

“For sophisticated investors, structured products provide a downside risk-reduction or buffering with upside participation. These types of instruments are not going to be necessarily useful to traders who go in and out of markets. But for investors who remain invested though, it’s a different story. Investors need to know how to position themselves.

“When things go well, you put the sail out and enjoy the bull run.

“But when you’re confronted with downside risk, you put the oars out. You have to find the right way to navigate the choppy waters. That’s when it really makes sense to switch to other instruments such as derivatives securities, options and options overlays.”

The most sophisticated investors are likely to look at structured products, he said.

“When the fear of missing out is no longer the main driver, it makes sense to give up some of the upside for some downside protection, especially if you can get that type of tradeoff built into one single product,” he said.

Big floater

Issuers last week focused on equity indexes (48.3% of total sales) while stocks and baskets of stocks made for less than 10% of total volume, reflecting risk-aversion.

The largest deals as always were index-based with a majority of worst-of issues, mainly consisting of two indexes rather than three. Stock deals were tiny. The largest one was UBS AG, London Branch’s $5 million Phoenix autocall on Tesla, Inc.

GS Finance Corp. showed some creativity with the pricing on Monday of at least four $750,000 offerings of buffered basket-linked notes. The unequally weighted baskets consisted of a large number of stocks ranging from 15 to 45 names.

There was only one rate deal, but its sheer size gave the category a 31.6% market share. It was Bank of Montreal’s $112.89 million of floating-rate notes due June 9, 2025 based on the two-year U.S. Dollar SOFR ICE Swap Rate.

The interest rate is the two-year U.S. Dollar SOFR ICE Swap Rate with a floor of 3.2%. Interest is payable quarterly. The payout at maturity will be par plus accrued interest. BMO Capital Markets Corp. is the underwriter.

Autocallable notes made for 35.5% of total sales last week versus 9.2% for leveraged notes.

Halo, Luma

On the distribution side, two partnerships were announced last week between fintech companies and other players in the distribution channels of structured notes.

On Thursday, fintech firm Halo Investing announced the integration of its structured notes platform with BNY Mellon's Pershing’s custodian software NetX360. The partnership between the fintech company and the giant clearing firm will provide financial advisers and independent broker-dealers a “seamless access,” to structured notes said Jason Barsema, co-founder and president of Halo, in a press release.

On Friday, Yieldstreet, a digital alternative investment platform, announced a partnership with another big fintech player, Luma Financial Technologies. Yieldstreet entered the structured products market a year ago.

The top agent last week was BMO Capital Markets Corp. with its $112.89 million trade. It was followed by UBS and JPMorgan.

The top issuer was Bank of Montreal.

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