Citi’s $3.14 million notes on S&P may work in bear market but inflation, lost decade is a risk

By Emma Trincal

New York, June 10 – Citigroup Global Markets Holdings Inc.’s $3.14 million of 0% market-linked notes – leveraged upside participation with quarterly averaging and minimum return at maturity due Dec. 4, 2028 linked to the S&P 500 index offer an original structure with high protection and unlimited returns, said Clemens Kownatzki, finance professor at Pepperdine University. It may be used in an equity allocation. But the payoff would not help in a “lost decade” scenario, which could occur with the convergence of a bear market and sky-high inflation.

The average index level will be the average of the index levels on each quarterly valuation date during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If the average index level is greater than the initial index level, the payout at maturity will be the greater of par plus 120% of the increase in the average index level and par plus the 2% minimum return.

Otherwise, investors will receive par plus 2%.

Distinctive terms

“To me, this note is pretty unique. It’s not so much the principal protection but the fact that you’re getting par plus 2%,” said Kownatzki.

“The tenor is unusual too. Six and a half years...that’s more than half a decade.

The quarterly averaging was also unique.

The averaging of the underlying performance is usually calculated during the last few days prior to maturity, he noted.

“It’s going to smooth out the return. It will help you make up for the losses if you encounter a crash at the end,” he said.

Overall, the structure had a lot to offer.

“It’s encouraging. Anytime you have principal protection with no cap and leverage on the upside, you have a good foundation,” he said.

Lost decade

Despite the structural benefits of the note, Kownatzki said he would still hesitate to invest in the product due to the current macroeconomic environment.

“Inflation is a problem, and it could get worse. If prices continue to spike, the principal protection plus 2% is not going to do anything for you,” he said.

“A 10% inflation rate would put enormous pressure on equities, bonds and other financial assets. A high inflation will erode returns. You could have negative returns. Or you could end up flat at the end of the term. Either way the payoff is not going to work to your advantage.”

Kownatzki said it was necessary to study past market cycles especially for young investors who have never gone through a bear market.

“Look back in history. After the dot.com bubble burst, it took 15 years for the Nasdaq to return to its early 2000 pre-crash level, he said.

For the S&P 500 index, the recovery from the peak in March 2000 took more than seven years with the index setting a fresh record high in October 2007. The following year, the benchmark dropped 38.5% as a result of the financial crisis.

Challenging asset allocation

“The 2000’s were the lost decade,” he said.

Despite intermittent rallies, bear markets, even if brief, will end up flattening market returns and possibly for a long time.

“When the market is flat the leverage is not going to help you nor will the 2% bonus. That’s the issue with the note.

“I like it. But I would be hesitant to use it,” he said.

With a soaring inflation, most traditional asset allocation models may have to be re-adjusted, he added.

“Some portfolio managers question the benefits of investing in equities at the moment. For some, commodities are the way to go. But you still need to allocate to equities at all times. The question is how much,” he said.

The 60/40 portfolio allocation (60% in equities and 40% in bonds) has been challenged lately, he said.

“That’s the traditional model. Another one is the famous: ‘put your age in bonds.’ But many analysts and portfolio managers are questioning the benefits of those traditional strategies,” he said.

One particular downside of the 60/40 portfolio in today’s market is the increased correlation between bonds and equities.

“We can see how stock and bond prices are falling simultaneously right now,” he said.

At least the notes may offer a solution to asset allocators, he said.

“Having 0% exposure to equities is not an option. You need the exposure. So a note that guarantees your principal plus 2% makes sense from that standpoint,” he said.

“You’re not going to get the dividends for six and a half years. But with the S&P yielding about 1.5%, you have enough leverage to make up for that loss.”

More pain to come

Despite significant losses in the market, the S&P 500 index remains overvalued, which makes the full downside protection all the more attractive, he said.

The S&P 500 index dropped 5.1% last week, finishing at 3,900.86, or 19% off its January high.

Kownatzki said he doubted the market hit bottom yet.

“If you look at a chart of the S&P 500 since 2007, we’re still above the long-term trend. The mid-range of the long-term range would be at 3,500,” he said.

While the current value of the index is not far from that level, it still remains 400 points higher, he noted.

“People are panicking over the index losing 15% to 20% this year. But there may be more to come,” he said.

The market always wins

While uncertainty and volatility prevail, investors are hard-pressed to decide where to invest their money.

“People are in a conundrum,” he said.

“Does it make sense to be invested in equities right now? And at the same time, can you afford not to have any exposure to the stock market?

“To some degree, the notes help solve that dilemma.

“Principal protection, as long as there is no cap, is attractive. It meets the needs of almost any type of investor.

“If you’re bearish, you have the protection. If you’re bullish, you have the unlimited return on the upside.

“I can’t find anything negative about the note.

“But even a good investment won’t win in a bad market. The red flag moving forward would be another lost decade. In that scenario, not just this note but most financial assets would be disappointing.”

The notes are guaranteed by Citigroup Inc.

Wells Fargo Securities and Citigroup Global Markets Inc. are the agents.

The notes settled on June 3.

The Cusip number is 17330FZQ7.

The fee is 4.53%.

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