Citigroup’s leveraged buffered notes on EM ETF offer reasonable alternative to long-only play

By Emma Trincal

New York, March 27 – Citigroup Global Markets Holdings Inc.’s 0% buffered notes linked to the iShares MSCI Emerging Markets ETF provide good timing with an attractive payout for investors seeking exposure to a relatively cheap asset class, said Steven Jon Kaplan, founder and portfolio manager at True Contrarian Investments. The only concern may be the length of the investment as a rally may come well ahead of the term of the notes.

The notes are expected to mature between 23 and 26 months after the trade date, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 1.6 times any ETF gain, up to a maximum return of par plus 42.128% to 49.424%. The exact maximum return will be set at pricing.

Investors will receive par if the ETF falls by up to 20% and will lose 1.25% for each 1% that the ETF falls beyond 20%.

Relative value

“This asset class is still relatively cheap, especially compared to the U.S. stock market, so I like it,” he said.

Despite the recent bear market, Kaplan said he still has to cherry pick U.S. sectors in order to find value.

“There are industries I like even better because they’re lower than their 2008 levels. I’ve been buying fertilizer companies, airlines, energy stocks.

“But most big indexes in the U.S. remain overvalued. It’s mainly because of those overinflated big tech companies – Apple, Amazon and Microsoft – everybody wants to buy.”

“It’s actually a good time to short those names,” he said.

But emerging markets stocks are in a different category.

“They’re not as overvalued as their U.S. counterparts even at the highest points,” he said.

The notes were different from most, he added.

“It’s not another note on the S&P or the Dow. You’re getting exposure to emerging markets, which is a much better place to be because you don’t have a fundamental overpricing,” he said.

Disappointing returns

Kaplan is selective in the emerging markets countries he buys, picking those that have recently seen sharp price drops.

“I was buying a lot of the Brazil ETF on Monday. The ETF was at its lowest since June 2016.

But even the EEM is down quite a bit since its January 2018 high of 49.53. It dropped 40% in about two years.

He was referring to the iShares MSCI Emerging Markets ETF, which is listed on the NYSE Arca under the symbol “EEM.”

“EEM was at 30.09 last Monday. Now it’s back at nearly 34. I don’t like to buy something that jumped 13% in less than a week. But I guess even now it’s still reasonably valued,” he said.

Emerging markets have not been popular among advisers. The memory of a 15% negative performance in 2018 followed by an 18.2% gain last year, which lagged the S&P 500 index’ return by more than 10 points, left value-hunters disenchanted with the lackluster performance.

Despite some very strong years, such as 2017, which recorded a 36.4% gain, the 10-year trailing return of the fund is 0.58%, according to Morningstar.

“People are not excited with EEM because they’ve gotten used to the U.S. markets going up every year. They’ve been crowding the same U.S. assets, the same big tech stocks,” he said.

“Now emerging markets are really one of the best places to be.

“They’ve never been more undervalued to the U.S. in the past two years and they’re still remarkably undervalued relative to the U.S. overall.”

Cap, buffer

Kaplan liked the structure of the notes.

“It’s really not too bad. If the fund was to go back to where it was at its peak in January 2018, that would be more than a 45% increase, and the cap is the equivalent to that,” he said.

He considered the midpoint of the cap range, which is 45.7%.

On a hypothetical 24-month duration, the 45.7% cap would provide a 20.7% annualized return on a compounded basis.

“I usually don’t like caps. A lot of them tend to really limit your upside. You pay a high price for the leverage,” he said.

“But this one is pretty good. You’re not giving much at all for 1.6 times the upside.

“If the ETF goes back to its former high, that’s more than a 45% jump, and that’s the equivalent of what you’re getting with the cap.”

The buffer was another positive aspect of the structure making the note compete favorably with the ETF.

While the downside was levered at a rate of 1.25, the first 20% losses remained protected, which made the protection more attractive than a barrier, all things being equal, he said.

For instance, a 35% decline in the share price would cause noteholders to lose 18.75% of principal, a much better outcome than owning the fund.

“This is one of the rare cases where you can find a real advantage in owning this versus the ETF,” he said.

The only “problem” with the notes was the two-year term.

“It’s not so much a dividend problem. The yield is 1.8%. You’re losing 3.6% over the term. That’s not huge,” he said.

The real issue was timing.

Maybe too long

The ETF could rally before the summer, he said.

“You could have a big rebound this year until the summer, and you could sell in August or September if that’s the case,” he said.

“The longer you go, the more this investment could wear off because we could definitely go into a recession in 2021.”

One bullish driver behind the growth of emerging markets is a lower dollar.

“The U.S. dollar had a pretty big drop recently. It’s going to weaken much more...it’s unavoidable. It has gone way too high,” he said.

As the market continues to sell off, more investors will be “crowding” in the greenback, but the momentum is almost over. From a technical standpoint, investors will begin to bet against the greenback, he said.

“The dollar is going to ease. It has already started,” he said.

Another factor was the passing on Friday of the “huge stimulus” package, which is inflationary in nature, he added.

Emerging markets benefit from a weaker dollar as they pay lower prices on imports from the United States.

Overall, Kaplan said the note was attractive.

“It may simply be a bit too long. I think most of the upside will take place before the summer.

“But the cap is good and so is the downside protection,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The Cusip number is 17328VGT1.

© 2015 Prospect News.
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