Citigroup’s capped annual notes on Cboe S&P 500 10% Buffered 25 April emulate buffered ETFs

By Emma Trincal

New York, April 20 – Citigroup Global Markets Holdings Inc.’s 0% capped annual buffer securities due April 30, 2029 linked to the Cboe S&P 500 10% Buffered 25 April index provide a structure very similar to what buffered ETFs – also known as defined outcome ETFs – have provided over the past four years in a fund wrapper. But sources said the notes are pricey in comparison.

The notes are putable and callable at the redemption amount on any annual redemption date, according to a 424B2 filing with the Securities and Exchange Commission.

The index is designed to reflect a 10% buffer against a decline of the S&P 500 index only with respect to a one-year.

The initial SPX participation cap for this note for the annual measurement period that begins on the pricing date will be between 9.75% and 11.75%. The exact cap will be set at pricing.

The Cboe S&P 500 10% Buffered 25 Index Series consists of 12 indices, each corresponding to one calendar month. Each index is designed to reflect buffered, capped participation in the performance of the S&P 500 index over successive one-year periods, beginning on the annual roll date.

With the notes set to price next week, the name of the underlying index reflects the month of issuance.

The payout upon the annual roll date will be the cumulative index return from the initial price to that roll date.

Innovator’s offspring

The structure of the notes is very comparable to the Innovator Defined Outcome ETFs, which Innovator Capital Management, LLC launched in 2018, raising billions in assets over a short period of time, sources said.

The Innovator ETFs have a one-year investment outcome period at the end of which the cap is recalculated.

The notes follow the same concept. On the annual roll date at the end of each annual measurement period, the index resets the cap based on the performance net of fees of the S&P 500 index.

Innovator is not the only asset manager specializing in defined outcome ETFs.

Cboe Vest LLC manages more than $6 billion in Target Outcome Investments, which offer various strategies other than buffered capped outcomes. This firm markets its investments in different formats, including ETFs, mutual funds and unit investment trusts, according to its website.

Some sources have attributed the slower issuance pace seen this year to the competition the structured notes industry faces with the growing popularity of the buffered ETFs. Another consequence of the appeal of those new funds among advisers, they said, is the rapid growth and predominance of autocallable notes versus traditional leveraged products in the structured notes space because autocallable payouts are not easily replicable in the mutual fund or ETF format.

Power of three

“Full circle,” said a sellsider about the Citigroup note.

“Buffered ETFs were created to mimic buffered notes and now structured notes are mimicking buffered ETFs, so it’s like a derivative on a derivative on a derivative, or a derivative cubed.”

An industry source agreed.

“Interesting. It looks like the banks are trying to compete with Innovator ETFs to get recurring revenue,” he said.

“After all, it’s not a bad thing. Anytime you have a new investment product being offered it’s more competition and that’s always a healthy trend.”

The notes make sense from an operational standpoint, he said.

“You don’t have to go through a process of having an auction with several issuers, bidding for the best terms. They’re launching a structured note, create it and that’s it,” he said.

Rich

But sources objected to the fee structure of the note.

Citigroup Global Markets Inc., the agent for the seven-year notes, receives a 0.25% underwriting fee, which is modest, sources said, given the tenor of the notes.

But the issuer disclosed a number of other fees.

An index fee of 0.25% per year accruing daily on the daily index level will reduce the performance of the index, according to the index supplement.

The cumulative effect of this index fee will be subtracted from the annual cap for any annual measurement period.

In addition, the index embeds an annual roll charge, which is deducted from the index level on the day after each annual roll date. The effect of this cost is also the reduction of the cap, according to the prospectus. For the first annual measurement period starting on the pricing date, the initial annual roll charge will be between 0.45% and 1.10% and its exact amount will be determined at pricing.

“If you didn’t roll the note, you could argue that the cost is comparable to a buffered ETF,” the sellsider said.

Most buffered ETFs charge between 0.80% and 0.85% per annum in expense ratio.

But such comparison would make little sense since the notes give investors the option to roll each year, he said.

“The notes become more expensive than an ETF if the holding period is short, which it probably is. Add to this the roll charge of 0.45% to 1.1% and it’s definitely more expensive,” he said.

A market participant agreed.

“It’s similar pretty much to a buffered ETF except it has more fees,” he said.

“You have a 25-basis points commission upfront. The ETF just has a maximum fee, the expense ratio and it’s charged daily, not upfront.

“Add the 25-bps index fee and on top of that the annual roll charge. Every time you roll, you get hit with a 1.1% fee. That’s an expensive product.”

Striking differences

The market participant said the notes offered limited benefits when compared with their ETF counterparts.

“With the notes, the cap is determined by the index. The index automatically uses market data to set the maximum return,” he said.

“With a buffered ETF, you have a portfolio manager that looks for the best cap in the marketplace. It’s done in the options market via market makers, so it’s a competitive process. You get the highest cap.”

The industry held a similar view.

“The CBOE index has been created and designed with a set of rules, like any algorithm. The cap and the terms are set in a very robotic way. With an ETF, the active manager can take steps outside of the rules. They have a little bit more discretion,” he said.

Buffered ETFs offered two other advantages over the notes, the market participant said – the daily liquidity at NAV and the removal of credit risk exposure.

Lack of approval

This raised the question: why bother with notes?

Some private banks lack the option to sell buffered ETFs. Using notes may be the only available alternative they may have, sources said.

“Certain banks have not allowed the distribution of buffered ETF internally,” the market participant said.

“The low cost of the buffered ETFs made them popular among fiduciaries. Everyone has access to ETFs. But within the private banks, it’s a different story. They haven’t really gained traction.

“In my opinion, the wirehouses have not approved those ETFs because they compete pretty well, almost too well with the more lucrative note business.

“The banks make so much money on these buffered notes. They would shoot themselves in the foot if they opened the door to those ETFs that are much cheaper, totally liquid and more transparent.”

The sellsider had a more balanced view.

“As issuers, banks can only issue notes. Wealth management arms of those banks are supposed to be product agnostic,” he said.

“That said, there was a lot of resistance on the part of private banks when these ETFs first came out. I’m not sure if it’s still the case now.”

It may still be the case, the market participant said, since buffered ETFs are mostly popular among fiduciaries.

“They are not private banks products,” he said.

One possible advantage of the notes versus the ETFs, at least for the banks, is the ease of creation.

“When you get to start the product, it’s easier to issue a note than launch a new ETF,” said the sellsider.

Credit risk exposure with the notes can have some advantages, said the market participant.

“There may be a gain when you’re subject to credit risk as a noteholder and that is to get a slightly higher cap. But bank spreads are so tight, I don’t think the credit risk premium you get is enough to offset all the fees,” he said.

The notes are guaranteed by Citigroup Inc.

The notes will settle price on April 26 and settle on April 29.

The Cusip number is 17330FJK8.

A similar offering priced a year ago on April 26, according to data compiled by Prospect News.

It was Citigroup Global Markets Holdings’ $450,000 of capped annual buffer securities due March 31, 2028 linked to the Cboe S&P 500 10% buffered 25 Mar index.

© 2015 Prospect News.
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