Citigroup’s 0.75% notes tied to bond ETF, Dow, Euro Stoxx cost too much in yield, sources say

By Emma Trincal

New York, March 7 – Citigroup Global Markets Holdings Inc.’s 0.75% market-linked notes due Sept. 29, 2022 linked to an equity basket of high-yielding assets “cost” too much in lost dividends, limiting the appeal of the notes except among investors whose main objective is to fully protect their principal, financial advisers said.

The components of the basket, each of which is weighted a third of the portfolio, are the Dow Jones industrial average, the Euro Stoxx 50 index and the iShares iBoxx $ High Yield Corporate Bond exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable semiannually.

If the average basket return is positive, the payout at maturity will be par plus 100% to 110% of the average basket return. The exact upside participation rate will be set at pricing. If the average basket return is zero or negative, the payout will be par.

The average basket return will be the average of the basket’s returns on the 24th day of each March, June, September and December during the term of the notes, beginning June 2017.

High-yield ETF

“Why include the iBoxx High Yield? Most of the return in this fund comes from the higher coupons. That’s why people are buying it,” said Tom Balcom, founder of 1650 Wealth Management.

Investors in the notes have to give up any interest payments on the bonds held by the ETF, according to the prospectus. Foregoing the dividends on the equity components of the basket is also part of the terms of the notes, as it is with most structured products.

“I’d rather have full equity exposure in my basket, not bonds,” he said.

The Dow Jones Industrial Average yields 2.16% and the Euro Stoxx 50 index, 3.27%. The distribution yield of the bond ETF is 5.20%. On average, investors are foregoing 3.55% a year in yield.

Balcom said the non-payment of dividends and yield represented too much of a drawback for him

“I know it’s the cost of protection in this low interest rate environment. But I don’t think it’s worth it,” he said.

“You’re giving up a lot of yield, and your money is tied up for five-and-a-half years,” he said.

Low leverage, OID

The small maximum amount of leverage at a rate of 1.1 times would hardly compensate for the “lost” dividends, he said.

And while the 0.75% coupon was “nice for some investors sitting in cash,” it was still not enough to replace the unpaid coupons and dividends.

“I’d rather have more leverage with a decent buffer. At least it would partially offset the loss of such a huge amount of return,” he noted.

Balcom said fully protected structured notes come with a tax disadvantage he is not fond of. Investors have to pay interest income taxes during the life of the notes, well before getting their final payout at maturity.

This type of interest called original issue discount (OID) is common to all notes issued at a discount. It is the case with zero-coupon bonds used to structure 100% principal-protected notes such as this one.

Complicated

Finally, Balcom said he did not like the quarterly averaging feature as it only added complexity.

“A basket that’s an average of three assets... A return calculation, which is computed every quarter. An average of 22 quarters at the end that gives you the final return... It becomes too complicated for most clients. “People want simple things.”

For some risk-adverse investors, however, the notes may serve a purpose.

“Many people prefer to stay in cash right now. At least this little coupon is an incentive to put your money somewhere. It’s a nice option for clients who hesitate to invest at all-time highs. It would be something that helps advisers get clients off the sidelines.”

No cap, but...

Donald McCoy, financial adviser of Planners Financial Services, was also disappointed by the “opportunity cost” of the structure based on the high-yield underlying basket components. But getting full downside protection is likely to be a strong plus for some clients, he added.

“The people who might be served by this would be more conservative investors who don’t want to lose at all,” he said.

Yet, using the “high-yielding items” in the note represented a significant sacrifice.

“If you look at the historical data, you see that some of those indices show high total returns. Take the Euro Stoxx for instance. It has been up 5.75% a year on a five-year trailing period. If you subtract the 3.25% dividend yield, that leaves you with only 2.5%,” he said.

“They’re not capping your upside. But you’re giving up a sizeable portion of the upside.”

Averaging

Finally, McCoy was not convinced that the quarterly averaging of the basket return offered any particular benefit.

If the idea was to reduce volatility, he said, the feature seemed counterintuitive since the notes already offered full guarantee against market downturns.

“It’s more of a head scratcher,” he said.

“Does it help the noteholder? I don’t have an answer to that.

“If it’s a hedge you’ll have to show it to me.

“Of course if the market crashes a month before maturity, you look like a genius.

“But as I see it, it raises more questions than answers.”

In conclusion, McCoy said the notes would have to be offered to a minority of investors with a particularly low risk tolerance.

“You’d have to be pretty conservative to be willing to give up that much yield for the promise of return of your principal over five-and-a-half year. It’s a long period of time.”

Citigroup Global Markets Inc. is the agent.

The notes, to be guaranteed by Citigroup Inc., will price March 24.

The Cusip number is 17324CG91.

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