Citigroup’s dual directional barrier notes to indexes seen as more appealing on the downside

By Emma Trincal

New York, Aug. 7 – Citigroup Global Markets Holdings Inc.’s 0% dual directional barrier securities due Aug. 29, 2025 linked to the worst performing of the S&P 500 index, the Dow Jones Industrial average and the Russell 2000 index offer potential outperformance on the downside and some distinct benefits on the upside, sources said. But the five-year tenor was a concern.

If the final level of the least-performing index is greater than or equal to its initial level, the payout at maturity will be par plus the greater of the digital return of 22% and the underlying return of the worst performing index, according to a 424B2 filing with the Securities and Exchange Commission.

If the final underlying value of the worst performing underlying is less than its initial underlying value but greater than or equal to its final barrier level, 70% of its initial price, the payout will be par plus the absolute return of the least-performing index’s return.

If the final level of either index is less than its barrier level, investors will lose 1% for every 1% that the least-performing index declines from its initial level.

Deciphering the worst of

“It’s an interesting note,” said Steve Doucette, financial adviser at Proctor Financial.

“You’re guaranteed this 22% minimum on the upside. That’s not much though. It’s basically a bond return.”

The exposure to the worst of three of the main U.S. equity indexes required some thinking in terms of asset allocation.

“You have to have some idea of which one of the three will be the worst of. Not so easy over five years,” he said.

“International stocks and small caps got slaughtered in this last downturn so they may come back up.

“The Russell is trading at a discount. It hasn’t done well. Small businesses have been struggling in this crisis. Many have been hit hard by the lockdowns. They should recover but it may be a long time coming.”

Unfortunately, investors in a worst-of note may not benefit from a recovery rally.

“If one or two of those indices are skyrocketing and you only get the weak return of the third one, you might be limiting your returns a lot,” he said.

“That’s the problem with worst of. It’s already hard to predict the return of one index in five years. Now you have to look at three.”

Tenor

The longer maturity offered a mixed picture.

“Five year out, I’m not too worried about the downside,” he said.

“The downside scenario gets to be more interesting. You can really outperform if you don’t bust that barrier.”

“With the absolute return, this worst-of turns into a best-of really.”

If the worst-performing index for instance drops 30%, investors will gain 30%.

“The more the index goes down the greater your return so long as you don’t breach. That’s a potential for a huge outperformance.”

But Doucette said he was hesitant to lock his money up for long periods of time.

“That might get me excited if it were a one or two year, which could never be structured.

“Sometimes the terms would be much better over a longer timeframe. Sometimes it’s the other way around.

“I guess that’s how those financial engineers mess with our minds.”

Correlations

For Clemens Kownatzki, an independent currency and options trader, the difficulty to hedge the downside was too big a hurdle.

The upside scenario and worst-of payouts were not a concern for this trader.

“The 22% digital seems like a small return, but it’s guaranteed,” he said.

“If things are moving in the right direction, you’re not limited on the upside, which is attractive.”

Investors in worst-of notes are better off when the underlying are highly correlated with each other, which is the case with this note linked to three U.S. equity benchmarks.

“I don’t think the correlation is a risk in terms of dispersion for this particular note. The Russell, the S&P and the Dow are highly correlated with each other,” he said.

“If the market goes down, correlations go close to one. I don’t think it’s an issue on the downside.”

A coefficient of correlation of one indicates a perfect correlation.

In a worst-of the “dispersion” risk is greater with less correlated assets as it only takes one poor performer to lower the return of the notes.

Big five

Kownatzki however expressed concerns about the use of the S&P 500 index.

“We know that five mega-cap stocks dominate the S&P due to their trillion dollars market cap. If things go well in the sector, the index will perform well. If not, you can have dramatic moves on the downside,” he said.

Alphabet Inc., Amazon.com, Inc., Apple Inc., Facebook, Inc. and Microsoft Corp. account for more than 22% of the S&P 500 index in weighting.

As a result, the S&P 500 index is no longer “reflecting” the market, he said.

“There’s really a disconnect between what you see in the economy and how the market performs.

“The Russell is more reflective of what we see in our daily lives. It shows the struggles of smaller companies in this pandemic. The other two are disconnected.”

Pin risk, uncertainty

Kownatzki cited two risks associated with the structure of the notes, saying he was not willing to take either one.

The worst of on the downside benefits note holders as long as the price doesn’t drop more than 30%, he noted.

“In this scenario, the worst of is your friend,” he said.

“But this is a pin risk I wouldn’t be comfortable with.

In options language the “pin” risk designates a severe change of outcome from positive to negative due to a barely noticeable price move.

“It’s like a huge digital cliff,” he said.

“The worst of is down 30%. Great! I’m up 30%. Now the price drops one basis point and all of a sudden, I lose 30.01%. Honestly, I wouldn’t know how to hedge this.

“It’s like flipping a coin, it’s either 50%, I’m up; 50%, I’m down.”

A buffer would have eliminated such risk. Perhaps a deeper barrier would also have helped although the “pin risk” remains intact with a barrier, he said.

“Thirty percent seems like a good downside protection. But we’ve seen that barrier being broken earlier this year,” he said.

The other drawback was the long maturity.

“This is a five-year note. It’s too long.

“If anyone comes up with a reasonable probability of where we’re going to be in five years, kudo!

“No one knows what will happen five years from now, especially after a year like this.

“Your guess is as good as mine.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes will price Aug. 26 and settle Aug. 31.

The Cusip number is 17328WJ66.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.