Citi’s $9.1 million buffered index-linked notes on MSCI EAFE offer mildly bullish play

By Emma Trincal

New York, Sept. 28 – Citigroup Global Markets Holdings Inc. priced $9.1 million of 0% buffered index-linked notes due Oct. 25, 2021 linked to the MSCI EAFE index, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 150% of any index gain, up to a cap of 12.15%.

Investors will receive par if the index falls by up to the 7% buffer and will lose 1.0753% for each 1% decline beyond the buffer.

“I would consider the note. It has a lot of pluses, a few negatives. But first you have to understand what your exposure is. For the most part, it’s Europe,” said Carl Kunhardt, wealth advisor at Quest Capital Management.

The MSCI EAFE index is the benchmark for developed markets outside of North America.

While Japan has a 26% weighting in the index, European countries, including non-members of the European Union, make for approximately 60% of the index.

Overweight Europe

“If you remove North America, which is the U.S., Canada and Mexico and outside of Japan, Australia and New-Zealand, you’re going to be left with Europe,” he said.

Kunhardt said he does not have a very positive view on European stocks.

“Europe has not completely imploded. But it’s not growing fast. Even though the [European Central Bank] took accommodative steps, the European stock market has been moving sideways,” he said.

“I’m not bullish on Europe. I’m not bearish either. I’m cautiously agnostic.”

Diversification was another important reason for owning the asset class.

“If I’m going to build an asset allocation and if I believe in asset allocation, I’m going to have to allocate developed markets to the portfolio. Just like I have to have U.S. large cap in my portfolio at all times. You may underweight it. But you still have to have it whether you like the asset class or not.”

Most portfolios allocate between 12% and 20% to international equity despite the “home bias,” which is the propensity of investors to overweight domestic equity, he added.

Structure

The structure of the notes offered a competitive advantage with a direct investment in the exchange-traded fund tracking the index.

“On the upside, if you don’t expect outsized returns, a little bit of leverage looks pretty attractive,” he said.

“On the downside you have a buffer. There is some leveraging but the multiple is so small.

If the market is down 27%, investors will lose 21.5% instead of 20% with a regular buffer.

“It’s a conversation you must have with a client but it’s an irrelevant conversation,” he said.

Based on his outlook on Europe, Kunhardt said the notes could fit in his portfolio.

“It all boils down to one final question: am I better off with this note than holding the position long?

“In this case, since I’m not a huge bull on Europe, the answer is yes.

“This note gives you leverage and some protection. The cap is not bad.

“I can see more benefits than not,” he said.

Geared buffers and taxes

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said the buffer, underlying and issuer were satisfactory.

“We have no problem with Citigroup’s credit especially when you’re talking about 13 months,” he said.

“The EAFE index is fine too. It’s the benchmark for most investors looking for international exposure.”

Kalscheur said he likes buffers, and this includes geared buffers.

“I’m a huge fan of geared buffers, especially for taxable accounts,” he said.

“Your principal is at risk and therefore you’re not subject to ordinary income tax. Since this one is longer than one year, you get long-term capital gains tax treatment, which is good.”

“Regarding the size, 7% doesn’t seem like much. But you’re still getting protection, so that’s something. It’s a small buffer but it’s a buffer, not a barrier.”

Double-digit cap

Kalscheur said he was also “comfortable” with the cap.

On an annualized compounded basis, the cap represents an 11.25% return, which can be obtained if the underlying index rises 7.52% per year.

“My goal is to get a double-digit return when I buy a structured note. So that’s a win.

“I’m getting a decent rate of return to make it worth my while being in equity,” he said.

Back-testing the downside

Kalscheur reviewed data he collected on the iShares MSCI EAFE ETF in order to assess the probabilities of return outcomes both on the upside and downside. He examined 13-month rolling periods since 2001, the date at which he began collecting the data.

His research showed that the index was down within the buffer zone 13.6% of the time.

“It’s pretty good. 13.6% of the time you’ll be fully protected. As the index goes down below that, you’re still protected but the protection narrows down.”

Investors give up a dividend yield of approximately 2.5%, he noted. But the buffer’s multiple is so small, the index would have to be cut approximately by half for investors to lose the advantage to the long-only position.

Defensive profile

There is a greater risk on the upside, he said. About 50% of the time, the index will increase above the cap.

“But this is not an issue if you expect this index to generate a mediocre return, which has been the case,” he said.

In the last five years, the annualized return of the EAFE index has been 4.85%.

“The leverage gives you a little bit of a kick. And the buffer makes the investment a little bit safer.

“For a fairly conservative investor who wants to get the exposure, it’s definitely serves a purpose.

“I wouldn’t use the note as a stand-alone investment but as a complement to an active manager. That’s usually how we like to invest in international markets.

“I can see this product making sense for some defensive investors. It’s a nice offering.

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes priced on Sept. 17 and settled on Sept. 24.

The Cusip number is 17328WCN6.

The fee is 0.8%.

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