Citigroup’s currency notes tied to euro offer attractive risk-reward for dollar bulls

By Emma Trincal

New York, Nov. 20 – Citigroup Inc.’s 0% currency-linked notes due Nov. 26, 2019 tied to the dollar relative to the euro, show an “interesting” risk-reward profile for dollar bulls, said Marc Chandler, global head of currency strategy with Brown Brothers Harriman.

But while the structure offers nearly full downside protection, investors are still taking risk on the five-year note and, by nature, currency markets are not necessarily likely to offer much upside, a skeptical market participant said.

The payout at maturity will be par plus 180% to 200% of any currency gain, with the exact leverage factor to be determined at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the currency return is zero or negative but greater than negative 5%, the payout will be par plus the currency return. If the currency return is equal to or less than negative 5%, investors will receive 95% of par.

Risk-reward

“I like the risk-reward profile of this note. It’s interesting,” said Chandler.

“I don’t know what the euro is going to be in five years. However the logic to this note is that even if we don’t know, it’s very likely that the dollar appreciation against the euro is going to continue for at least two years if not three. That’s simply because the [European Central Bank] is engaged in doing its own version of [quantitative easing] for the next two years. They’re not going to raise rates during that time. The idea is that for the next two to three years, the euro is likely to trade lower,” he said.

Since July, the dollar has appreciated 8% versus the euro, pushed by market expectations of higher rates in the United States coupled with implementation of a stimulus policy by the ECB.

The ECB put

“We don’t know when the ECB will stop easing but at some point sooner in time the Fed is going to raise rates,” said Chandler.

“Even if the dollar rally doesn’t last through the five years, the idea is that the dollar will appreciate significantly in the early half of the term to offset a decline further in time if there is one.”

He offered a hypothetical example. If the euro fell by 20% over the next two years and then recovered but only by 5%, investors would still profit to a large degree especially with the leverage.

“This risk-reward is really interesting. Let’s say you invest $100,000. You can double up and make $200,000 and not lose more than $5,000.

“I invest $100,000. I have twice the return on the upside with unlimited gains and I won’t lose more than $5,000.

“Let’s compare it with investing in a five-year government bond assuming a 2.5% yield. Two and a half percent compounded over five years is 12%.

“So I can get 12% with no risk or get into the Citi notes and make 200% by taking a risk of 5%.”

Chandler said he did not take into account credit risk.

“Citi is still going to be around five years from now because it’s too big to fail.”

Despite the appeal of the payout, Chandler said currency notes, just as currencies in general, are not a favorite among small investors.

“Even if they can invest small amounts of money, the currency market is kind of complicated for most U.S. investors. It’s a 24-hours a day market. Most of it takes place out of the U.S. Retail investors don’t really look at it,” he said.

The minimum denomination for the notes is $1,000, according to the prospectus.

Tricky trade

A market participant said that the “U.S./euro currency trade is very tricky.”

He acknowledged the sharpness of the dollar rally but said it had only been happening over the recent months.

“For the past two years, the euro has stayed in a narrow band, between 1.30 and 1.35 and never moved from there,” he said.

“Now it’s at 1.25 but for how long?

“If you look at the terms, you can certainly say, ‘Sure, I’m only losing 5% worst case scenario; I have two-times leverage; no cap on my return.’ If the dollar moves up in your favor, it can be a very profitable trade.”

He insisted that the odds of generating gains in the currency market were small.

“Currencies can trade in a range for very long periods of time, move a couple of basis points, which is not making anyone super-rich.

“If the euro stabilizes, it’s likely to bounce back very quickly.

“You’re taking a five-year exposure. A lot can happen in five years. While the risk-reward profile seems attractive and may justify doing the trade for some, in reality you have to look at the odds of making a significant profit.”

Technically, the dollar should strengthen further if the Federal Reserve raises interest rates, he noted.

“But we’ve been hearing about the U.S. raising rates for a very long time.

“You’re depending on two central banks managing their respective currencies. The U.S. has been successful in keeping the dollar weak for a long time. But are we economically strong enough to shift from zero interest rates to higher rates? And if we do that, are we the only ones doing that? A lot depends on how the ECB and the Fed will interact and who will be doing what and when in terms of monetary policy.

“So you may be only taking 5% risk but the odds of making money are not that great,” he said.

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price Nov. 21 and settle three business days later.

The Cusip number is 1730T03E7.

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