Citi’s barrier range accrual notes linked to S&P 500 swap equity risk for yield, adviser says

By Emma Trincal

New York, June 9 – Citigroup Inc.’s callable barrier range accrual notes due June 27, 2025 linked to the S&P 500 index provide an above-average yield in exchange for risks that are not usually borne by plain vanilla bond investors, a financial adviser said.

The interest rate will be 7% per year multiplied by the proportion of days on which the index closes at or above the accrual barrier level, which will be 75% of the initial index level. Interest will be payable monthly, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par unless the index finishes at or below the final barrier level, in which case investors will share fully in losses. The final barrier level will be 60% of the initial index level.

Equity risk

“You’re trading your equity risk for a variable income risk. The S&P could be down 22%, you would still be picking up income. It’s an equity swap for a contingent coupon,” said Juin Chin, senior investment analyst at Modera Wealth Management, LLC.

“I haven’t seen that kind of structure before. There is complexity in terms of understanding what it does and keeping track of it. You have to trust the provider to calculate the accrual properly.”

The low interest rate environment explained why some investors would be drawn to those types of products, another adviser said.

“There is a thirst for yield in the market, and banks are forced to come up with ideas on how to solve this issue,” said Tom Balcom, founder of 1650 Wealth Management.

“This one will give you the 7% yield each time the index is above the 75% barrier. Compared to the 10-year Treasury at 2.4%, you’re getting a premium. Anything above that is your risk.”

Coupon at risk

With a variable coupon, investors are not guaranteed to be paid, he noted. But such risk is not among the most difficult to take, in his view.

“For someone who wants some yield, as long as the S&P doesn’t breach the barrier you’re going to get it. If there is a pullback of 25% or more, you won’t earn the coupon. However, this calculation is done each day. You could have the market down 25% or more for half of a year and still earn 3.5%. And if we really have a market correction, if the market falls by 25% or more, I doubt very much that clients would be upset to earn 3.5% instead of 7%. So I don’t really have an issue with the variable coupon,” he said.

Credit risk is not worse than with any longer-dated bond, he noted.

The risk of losing principal at the end is limited as well with the deep 60% barrier.

Rising yields

“My biggest issue is interest rate risk,” he said.

“As interest rates will go up, the value of the bond will go down. Then you have clients who will say, ‘I gave you $1,000 and my bond is now worth $900 for a coupon that’s capped. What happened?’ How do you explain that situation to a client?

“Clients look at their statements all the time. When it’s down, they’re not happy. Retail investors don’t hold a note for 10 years. They need cash. You would have a lot of explaining to do when rates go up.

“Right now the 10-year risk-free rate is 2.4%. Anything above that is risk: coupon risk, interest rate risk, market risk, credit risk.

“I’m particularly concerned with interest rate risk, which is why we keep our bond durations short. Even for structured notes, we try to keep them under two-and-a-half year.”

Downside barrier, term

One of the product’s strengths is the final 60% barrier protection.

“The risk of losing principal at maturity is limited, especially after 10 years. It would have to be a pretty bleak scenario,” he said.

“Because the note provides a coupon and some protection, you may want to use it as a hedge to protect an existing exposure to the S&P.”

But Chin said he is “not too excited” about the long duration of the product.

The notes are callable after one year at par on any interest payment date at the discretion of the issuer, according to the prospectus. As a result, investors don’t know the exact duration of their investment. But the stated maturity is too long, said Chin.

“Over 10 years the market tends to rise. I would think that over 10 years, you could do better than 7% a year, but I don’t have a crystal ball,” he said.

“The trade-off is still reasonable though. You’re swapping equity risk for more protection and income.

“The million-dollar question is you have to have a crystal ball to predict long term the return of the market and see if the investment was worth it. But the protection is there.”

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price June 24.

The Cusip number is 17298CCC0.

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