Citigroup’s notes linked to S&P 100 index offer mega-cap exposure through rarely used index

By Emma Trincal

New York, March 10 – Citigroup Inc.’s 0% geared buffer securities due April 4, 2019 linked to the S&P 100 index offer a long-term equity play on the largest U.S. companies via an easy-to-understand structure and a lesser-known underlying benchmark.

If the final index level is greater than the initial level, the payout at maturity will be par plus 121% to 131% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to 20% and will lose 1.25% for every 1% that it declines beyond 20%.

Rare

The S&P 100 has barely been used in structured notes, at least when compared to its broader counterpart, the S&P 500 index.

The S&P 100 is a subset of the S&P 500 that comprises 100 leading U.S. stocks. The index is market-capitalization weighted. Its top three constituents are Apple, Inc., Microsoft Corp. and Exxon Mobil Corp.

Despite the fact that such stocks are widely followed, the index itself has rarely been employed in the structuring of notes.

Since January 2007, the volume of notes linked to the S&P 100 is only $407 million versus $81 billion on the S&P 500, according to data compiled by Prospect News. As a percentage of the total notional issued during this period, S&P 100-linked notes account for only 0.1% versus 22% for the S&P 500.

Less volume

A market participant explained why.

“The appeal of the story is important. The S&P 500 benefits from a huge name recognition, which is not the case for the S&P 100,” he said.

Joe Bell, senior equity analyst at Schaeffer's Investment Research, said that options on the S&P 100 are much less liquid than those on the S&P 500.

“It comes down to how many people use them. How much open interest. How much people use them as a hedge. The S&P is much more widely followed. The options on the S&P 100 are not trading nearly as much,” he said.

Firms prefer to use indexes with high option volume as it facilitates hedging and reduces the cost of pricing.

“If the options on the S&P 100 are liquid, they aren’t as much liquid as the options on the S&P,” the market participant said.

“There is no comparison between the depth of the market for the S&P 500 and the S&P 100, which is a more concentrated representation of the market.”

One hundred biggies

Concentration is precisely an issue for Steve Doucette, financial adviser at Proctor Financial.

“From the S&P 500 to the S&P 100 to a single stock, you have that whole range. I’m always geared toward the broader benchmarks,” Doucette said.

“One hundred stocks with large concentrations on the top names and sectors, it’s not diversified enough for us.”

The top five holdings combined account for more than 17% of the index, according to BlackRock Investments, which distributes the iShares S&P 100, an exchange-traded fund that tracks the index.

The overconcentration of the index in information technology is also “a lot,” he said.

The IT sector represents 24.5% of the index; health-care stocks have a 15.13% weighting, and financials have a 13.56% weighting.

Among the less represented sectors are energy and telecoms with a 7.26% and 4% weighting, respectively. Utilities make for less than 1%.

“The problem with these concentrated indexes is that if the market pulls back, you might be hit harder than if you were exposed to a broader benchmark,” he said.

Vanilla

Doucette expressed more interest in the structure of the notes, saying that its simplicity is compelling.

“It’s a pretty vanilla structure. ... It’s got a nice little bump with the leverage and no cap. ... That’s pretty strong. And you still have a buffer on the downside,” he said.

“These are the notes where no matter where you’re going to be you’ll probably outperform.”

The downside leverage was not a concern to him. On the contrary, he said he does not understand why so many financial advisers are still reluctant to use geared buffers.

“The market would have to drop like a rock for you to lose as much with the notes,” he said.

“If the index is down 50%, you’re going to lose 37.5%. You still outperform the benchmark. With a 20% normal buffer you would lose 30%. So I guess you can say it’s worse than a traditional buffer, but you’re doing so much better than being long-only.”

Capital gains

Another lesser-known advantage of geared buffers is their preferential tax treatment, he noted.

Unlike returns generated by structured notes with a standard buffer, which are subject to ordinary income tax, securities in which the entire principal is at risk are subject to capital loss or gain taxes, he said.

In the tax section of the prospectus, the issuer said the notes are likely to be treated as a “prepaid forward contract for U.S. federal income tax purpose,” which means that investors will not be requested to recognize gains or losses as ordinary income but instead will benefit from capital loss or gain tax treatment.

“We usually have some flexibility when it comes to the type of account we use for our clients. But for some wealthy clients not having to be subject to income tax would be a plus,” he said.

“I like these basic structures. They’re the most logical to me because you outperform in both directions until you hit some extreme.”

Too long

Matt Medeiros, president and chief executive of the Institute for Wealth Management, also liked the terms.

“Generally speaking a 20% buffer is attractive. I would think that the downside leverage after the gearing should be a consideration for an investor. You’d have to keep in mind the trade-off you get, as far as we know, with the more favorable tax treatment,” he said.

The “little bit of leverage on the upside” with no cap is also attractive, he added.

Medeiros liked the idea of getting exposure to mega-cap stocks.

“The benefit of ultra-large caps is that equity markets will flow into larger caps in a choppy market before it flows into smaller caps,” he said.

“I like the underlying index. My hesitation would be with the term.

“We anticipate that the choppy markets that we’ve had in the past 10 months or so will continue to have an impact short-term. Five years though is kind of on the outskirts of our market assumptions.

“With the headwinds we see in the markets, taking a five-year view in a structured note is a bit of a challenge for me.”

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 17298CD39) are expected to price on March 30 and settle three business days after pricing.

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