Citigroup’s barrier notes on S&P provide absolute return, protection in ‘condor-like’ deal

By Emma Trincal

New York, July 23 – Citigroup Global Markets Holdings Inc.’s 0% barrier absolute return market-linked notes with daily barrier observation due July 30, 2020 linked to the S&P 500 index are one of the latest issue of a newer structure combining absolute return, principal protection plus a slight guaranteed coupon.

A barrier event will occur if the index closes above the upper barrier, expected to be between 124% and 125% of the initial level, or below the lower barrier, expected to be between 75% and 76% of the initial level, during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If a barrier event occurs, the payout at maturity will be par of $1,000 plus 2%.

If no barrier event occurs, the payout will be par plus the absolute value of the index return.

No need for cash

“I love it!” said Carl Kunhardt, wealth advisor at Quest Capital Management, who said he never saw that type of note before.

The most difficult choice for investors, he explained, is to decide whether to be in the market or to stay on the sidelines with cash.

“This is really the key decision,” he said.

“This note removes the cash as an option. No need to consider cash since you can do just about the same thing with 2% while still being able to participate in the market.”

Modest returns

The structure reflected exactly the market outlook of his firm, he added.

“There has been increasing talk of a market pullback in 2019. That’s the perspective I’m looking at,” he said. “Some are saying that we’ve heard that before and that it hasn’t happened so far. But nine years into a bull market, you have to at least consider a market correction.

“The note does just that. It removes all of the risk for me.”

Kunhardt at first referred to market risk, against which investors are fully protected. But even the exposure to the issuer’s credit was not seen as a concern.

“After the financial crisis, there’s no way an American government, left or right, would let any big U.S. bank fail. Besides it’s Citi. I don’t think there’s a lot of credit risk there,” he said.

Kunhardt looked at the range between the initial price and the upper barrier.

“You have 24% in potential upside in two years. I don’t particularly like caps, but 12% on an annualized basis is way above what I’m expecting from the market.”

Kunhardt said that using projections from Mercer, he expects U.S. stocks to generate an 8¼% return on an annualized basis over the next 20 years.

“There will be a lot of big ups, a lot of big downs. But in average, they’re not expecting more than 8¼% a year,” he said.

Quest Capital uses those metrics for its asset allocation and financial planning.

“Given those numbers, I’m not really seeing the 12% per year cap as a negative,” he said.

But perhaps the most appealing feature was to be able to get more than the initial investment back.

Par plus 2%

In the worst-case scenario, when one of the barriers is breached during the term, investors will receive a 2% fixed return.

A cash-alternative using a two-year Treasury would bring 60 basis points in additional return, which he said is not much compared to the 2% guaranteed by the notes in addition to the potential for market-linked returns.

“This note takes the cash option off the table. No more dilemmas between cash and equity. Why would I do cash when I can make 24% in an up or down market?

“If I’m wrong, I get my money back plus 2%. That’s more or less the equivalent of cash.

“If the market falls and I never breach, it’s a home-run,” he said.

Distribution channel

Kunhardt said he would seriously consider investing in the notes if he could.

“Unfortunately, UBS deals don’t tend to show up on the Raymond James desk.

“It’s a great deal I can’t use.”

Quest Capital Management is a registered investment adviser affiliated with Raymond James.

Innovation

This type of structure is relatively new. According to data compiled by Prospect News, one of the first such deals came out at the end of May. UBS sold it on the behalf of Credit Suisse AG for $19.32 million. Some sources have tabbed the structure “condor” as a result of the wing-like shape of the risk-return diagram. The long condor is a specific option strategy, which wins when volatility remains contained. It consists of calls and put spreads.

“I’ve noticed this structure. It’s extremely innovative. I’ve never seen that combination of dual directional plus full protection before,” said Brady Beals, director of business development at Navian Capital.

“So far it’s being distributed in the UBS [registered investment adviser’s] space.

“There’s a growing interest in principal protection among RIAs. Dual directional features are also increasingly popular. We’re getting requests for dual directional notes all the time. People don’t necessarily expect a bear market. But they think the market will trade sideways. The structure takes advantage of it.”

The strategy is likely to gain in popularity as it guarantees the repayment of principal plus a small extra coupon in the worst-case scenario. If prices stay within the upper-to-lower range, investors will participate in both the upside and the downside on an absolute return basis, he noted.

A trend

Those structures have all in common the principal-protection; a relatively short-term tenor (14 to 24 months); a guaranteed coupon if the knock-out event occurs; equal positive return on a one-to-one basis between the two barriers, which cap gains on both sides of the trade.

What will vary is the width of the range between the barriers, the amount of the fixed payment and also the nature of the barrier. When monitored on any trading day as is the case with this product, the barrier is known as “American” by opposition to a European barrier, which is only observed at maturity.

Beals said that more 100% or 90% to 95% principal protections have recently emerged due to the rise in interest rates.

The discount on the zero-coupon bond is deep enough to provide the necessary “budget” to buy the options, he explained.

Pricing

Some expressed surprise at the way principal-protection can be achieved over such a short period of time.

“Full principal-protection? On a two-year? That’s the first thing that caught my attention,” said Kunhardt.

The structure involves several option “legs,” explained Beals. One of them is a call spread: long an at-the-money call plus short an out-of-the-money call. This piece of the structure offers the one-to-one upside up to the upper barrier.

“The cleverness of this product is to link the return to the S&P,” he said.

A similar structure could not price on the Euro Stoxx 50 index, he added. This benchmark has a higher dividend yield and trades in a negative interest rate market in Europe. As such, it fails to offer enough premium when selling the calls.

“It’s not the case when you sell calls on the S&P,” he said.

“You’ll get enough premium to buy the calls and put the absolute return in there.”

The majority of the recent deals using this structure have indeed been built around the U.S. benchmark, according to data compiled by Prospect News.

The yield curve is also a factor.

“The curve is so flat; it allows issuers to shorten the terms,” he said.

Stay tuned

UBS appears to have come up with the idea. It has so far been the sole large firm to distribute those products at the exception of JPMorgan, which priced a $5 million deal as well at the end of last month.

“We’re looking into this very closely,” Beals said.

“I’m sure we’re going to see more of those products.

“I wouldn’t be surprised to see this structure in a CD wrapper in a few months. It may not be a two years maturity but I’m sure it will be done.

“Inevitably, when there is innovation, you’ll see firms imitating the original product. We’ll see more of this soon and not just from UBS.”

The notes will be guaranteed by Citigroup Inc.

The exact barriers will be set at pricing.

Citigroup Global Markets Inc. and UBS Financial Services Inc. are the agents.

The notes will price on Thursday and settle on July 31.

The Cusip is 17324CY67.

© 2015 Prospect News.
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