Citi’s barrier notes with upside reset on Dow ETF set novel way to enhance upside potential

By Emma Trincal

New York, April 23 – Citigroup Global Markets Holdings Inc.’s 0% barrier securities with upside reset feature due April 29, 2025 linked to the SPDR Dow Jones industrial average ETF trust give investors extra upside potential by allowing the initial strike price to reset downward under certain conditions.

The structure belongs to the wide category of lookback notes although its benefits apply to the “upside” return rather than to the downside protection. Advisers had different reactions based on the structure itself, which is not entirely straightforward, one of them said, as well as based on their market outlook.

Reset

The prospectus defines an “upside barrier” value as the initial underlying value unless a reset event has occurred, in which case the upside barrier value will be 85% to 90% of the initial underlying value.

For simplicity, advisers used a hypothetical 90% level as the upside barrier.

A reset event will occur if the underlier closes below 90% of the initial price, according to a 424B2 filing with the Securities and Exchange Commission.

Such reset is only observed until April 26, 2021 but on any trading day during that one-year window, which increases the chances for the event to occur.

Three strikes

The structure introduces a layer of complexity with three strikes: the downside barrier at 80%, the upside barrier at 90% in the event of a reset and the initial price of 100.

If the final underlying value is greater than the upside barrier value, the payout at maturity will be par plus the return of the underlier.

If (under the reset scenario) the upside barrier is at 90% and not at 100%, the return will be measured on absolute value terms by any percentage point above 90%.

If the final underlying value is below the upside barrier value but above the 80% downside barrier value, the payout will be par.

If the 80% downside barrier is breached, losses will be counted from the initial price as it always is.

Investors will be paid in shares or cash, at the issuer’s option.

Tiny margin

Steve Doucette, financial adviser at Proctor Financial, said he does not mind complexity if it is useful. But he did not think the reset mechanism was particularly useful while certainly complex. This was due to his bullish market outlook long term.

“Financial engineering people are spending a lot of time working on a tiny range below zero and minus 10%,” he said.

The reset and the upside barrier did not change anything about the downside: investors have a 20% contingent protection, or an 80% European barrier.

The term “European” designates a point-to-point observation.

“I’m not too concerned about the 80% barrier. It’s a five year and we already had a pullback,” he said.

Barrier breach

Regarding the benefit of the reset event, which would set the upside barrier at 90%, he distinguished different scenarios.

First the downside. Any drop below 80% will activate the normal knock-out of the European barrier, giving investors full downside exposure.

“Nothing is new here,” he said.

Principal back

The principal-protection with the return of par at maturity will occur if the price falls between the two barriers or within the 80% to 90% range.

“It’s only 10 points. Pretty thin range,” he added.

Reset benefit

The structure becomes more innovative when the price finishes negative but above the upside barrier of 90%, he said.

In this case any point above 90% translates into an absolute return of plus 1%.

“It’s strange that you’ll get paid more if the price is down only a little bit and less if it drops close to 10%,” he observed.

Indeed, a final price of 91%, which is a 9% drop, represents only 1% above the upside barrier and therefore, translates into a meager 1% gain.

On the other hand, if the price falls to 99%, a 1% decline, investors will pocket 9% in profit.

More with less vol.

“It’s almost the opposite of an absolute return deal when you make more as you get closer to the barrier,” he noted.

“The component of this note between zero and minus 10% makes absolutely no sense to me.”

To be sure, the downside payout above the upside barrier is more advantageous to the investor in a low volatile scenario when the price decline is contained.

“All I can tell is that it’s really a lot of work for a tiny 10-point range. The probability of falling in that range is small,” he said.

Finally, for a financial adviser, getting the client to understand the various “moving parts” of the structure was a challenge.

“How do you explain this reset and those two barriers to a client? I have no idea.”

Adding 10%

The “upside” payout, or the gains captured when the ETF finishes above its initial price, is much easier to explain and understand. But Doucette did not like it because the note may pay less than what his bullish outlook anticipates gaining over a five-year holding period.

“Here, it’s more straightforward. They pay you a 10% bonus in addition to the index return,” he said.

Indeed, if the ETF finishes up 40% for example, investors will receive the 10% they are entitled to get on the downside from the 10% spread between the upside barrier and par, plus the index gain above initial price.

Leverage preferred

“But five years out, I’d rather be locked in for leverage than for a 10% bonus. You can easily make 2% a year on a five-year. This extra return has little value to me compared to leveraging your upside and let it compound over that period, especially with prices as low as they are now,” he said.

“This deal is not going to be bought. It’s going to be sold.”

One off

Matt Medeiros, president, and chief executive at the Institute for Wealth Management, said he believed the notes were probably bought at the request of a client, via a reverse inquiry.

“What comes to mind is that it’s a note created for a specific situation,” he said.

“I wouldn’t be surprised if it was an institutional deal.”

“It would be for a client who’s still concerned about the short-term volatility of the index but who is more optimistic about it after the next 12 months.”

Buffer is a must

“I see opportunities in this asset class for the next five years,” he added.

“But personally, it would not be a good fit for my portfolio. I’d rather be more defensive and use a buffer instead of a barrier.”

If the underlying drops more than 20%, in effect, if it breaches the 80% downside barrier, the reset and upside barrier are of no help to prevent losses, he explained.

“If my focus was volatility, I would want a hard protection. That’s what I usually look for with structured notes.”

Creative

The sophisticated structure was not a setback.

“It is an interesting trade. I get it. They are trying to address a client’s concern with headwinds and to manage the opportunity by moving the initial price lower.

“I don’t particularly object to the complexity of the structure.

“They’ve done a good job trying to strike a fair balance between where the market is today and where it may be in five years.

“It’s innovative. I think it’s a good type of engineering,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 17324XYH7) will price on Friday.

© 2015 Prospect News.
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