Citigroup’s notes with variable coupon linked to 10 stocks may do poorly due to cap, asymmetry

By Emma Trincal

New York, Oct. 21 – Citigroup Inc.’s variable-coupon notes due Oct. 25, 2021 linked to a basket of stocks give investors an opportunity to earn above-average income, but the calculation of the basket performance that determines the coupon amount limits the return, sources said.

The notes will pay a coupon each year equal to the average of the basket stocks’ performances, subject to a minimum rate of zero, according to a 424B2 filing with the Securities and Exchange Commission.

If a basket stock’s return is zero or positive, its performance will be 10.4%. If a basket stock’s return is negative, its performance will be the greater of its return and negative 30%.

The payout at maturity will be par.

The equally weighted basket, based on companies in the technology and manufacturing sectors, includes SunEdison, Inc., Adobe Systems Inc., Delphi Automotive plc, International Business Machines Corp., Honeywell International Inc., 3D Systems Corp., Google Inc., salesforce.com, inc., Bunge Ltd. and Applied Materials, Inc.

“I think this note will likely disappoint as it will not perform as well over the seven years as the actual stock basket,” said Dean Zayed, chief executive officer of Brookstone Capital Management.

Early drop

The cumulative basis used to calculate performance versus an annual reset is his first objection to the deal.

“If one or just a few of the stocks drop considerably early on from the initial price, this can potentially negatively impact the performance of the note for all seven years. An annual reset would be very beneficial instead, so that a stock’s early performance doesn’t continue to hurt the note,” he said.

He offered an example: One of the stocks in the basket begins at $10 and drop to $7 the next year to stay at the same price the following year. The cumulative method used in the structure would generate two losses of 30% each. An annual reset would have generated a 30% loss only for the first year and no loss on the second year as the return was flat.

“Investors are penalized in the second year for a price decline that occurred on the first year,” he said.

Spoiled by a few

Because of asymmetry between the upside cap of 10.4% and the 30% floor on the downside, a few bad trades can really “spoil” the overall performance, he said.

He gave another example: Seven stocks in the basket show positive returns and get the 10.4% interest. The three other stocks fall in price by 25% each. In this scenario, 70% of the basket is showing positive returns, yet the note earns zero interest.

“Compound this issue with the industry concentration that the stocks represent here and you can envision a scenario where the basket of stocks collectively produces zero returns or low returns for the noteholders,” he said.

Finally, the noteholder forgoes the dividends, which also penalizes the investor, he concluded.

Asymmetry

Steven Foldes, vice chairman at Evensky & Katz/Foldes Financial Wealth Management, said the cumulative approach should be a plus. But his main concern is the asymmetry between the cap and the floor used to determine the return of each individual stock.

“On the upside, if a stock does very little or nothing, you do get a 10.4% return. But the problem is that your return is capped at that level. You can’t get more than 10.4%,” he said.

“On the downside, however, you can incur as much as a 30% loss. That’s a significant gap.

“There is more room to lose money on the downside than there is to gain on the upside.

“If a couple of stocks get hit, you will suffer from that.”

Cumulative return

On the other hand, the calculation of the performance of each stock based on its cumulative return versus year over year is beneficial to the investor, he said.

“By establishing the base price as the date of issuance, you can benefit from the long-term upward performance,” he said.

“This appears to be beneficial. The longer you hold the notes, the greater the likelihood of getting 10.4%.

“Unfortunately, the disparity between the 30% limit on the downside and the 10.4% cap on the upside more than offsets this benefit.”

Full protection

Foldes said that he likes the full principal protection even if it means that the tax treatment of the notes is ordinary income.

“For all the notes we invest in, the money we make is treated as long-term capital gain, so it’s not as attractive. But that’s the nature of principal protection, and we understand that,” he said.

“Obviously the credit quality of the bank is an issue. But Citigroup’s credit is reasonably good relative to other large U.S. banks.”

In his view, the duration is not a major drawback due to the return calculation method.

“Normally, I would be unhappy with seven years but not in this instance simply because of the cumulative nature of the pricing. Every year, the likelihood of getting your 10.4% coupon increases,” he said.

“Unfortunately, it’s only a 10.4% return, and you are not guaranteed to earn it every single year.

“Your underlying stocks can drop three times more than they can go up. These are volatile stocks. Tech stocks are going to be volatile.”

This leads to the risk of having no coupon if a couple of poorly performing stocks hurt the overall performance, he said.

Citigroup Global Markets Inc. is the underwriter.

The notes were expected to price Tuesday.

The Cusip number is 1730T02R9.

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