Citigroup’s enhanced buffered digital securities linked to Russell 2000 index show bearish bias

By Emma Trincal

New York, May 16 – Citigroup Global Markets Holdings Inc.’s 0% enhanced buffered digital securities due May 31, 2019 linked to the Russell 2000 index will appeal to cautious investors expecting very limited upside and possibly a correction in the small-cap stock market, advisers said.

That’s because the digital note is constructed with a slightly bearish bias: Investors may get the digital payment when the market is down and not just when it’s up as long as the index decline does not fall below a buffer threshold.

If the index finishes above its initial level or falls by up to the 15% buffer, the payout at maturity will be par plus the fixed return of 16% to 19%. Otherwise, investors will lose 1% for every 1% decline beyond 15%.

The exact fixed return will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are guaranteed by Citigroup Inc.

Slightly bearish

“The risk-reward is pretty favorable for someone who wants a little bit of protection on the downside,” said Jerrod Dawson, director of investment research at Quest Capital Management.

“For investors who have a little bit of a bearish outlook, it’s interesting. You can outperform the index easily.”

If the market is negative up to the 15% buffer level, investors will make at least 16%, beating the index in that scenario by more than 30 percentage points, he noted.

The digital payment is also a cap: Investors will see their return limited to the fixed payment of 16% to 19%.

“The upside is not very high. Say they give you about 5.5% a year, depending on where they set the cap. It doesn’t seem like a lot. But in this low return environment it’s a good outcome considering the performance of the Russell, an index that’s still overvalued on a historical basis.”

Hedging some volatility

The small-cap benchmark is down 1.15% this year. It lost 4.5% last year.

“Volatility is still on the rise, and this index is more volatile than the large-cap index.”

Dawson said that despite its volatility, some of his clients want exposure to the Russell 2000.

“Historically it has more upside potential. That’s why they’re buying it,” he said.

But the risk is greater on the downside. In a downturn, the Russell 2000 tends to underperform the S&P 500, he noted.

“I wouldn’t invest in the Russell 2000. Personally, I would want to buy the higher cap or something like this note when you can get a little bit of protection.”

“I like the structure.”

Mild is too strong

The notes would not be a good fit for “very” bullish or “very” bearish investors, a financial adviser said.

“If you’re ultra-bullish on the Russell, this is not a play for you,” he said.

“It’s more like you have to be scared about the market. ... This note has a slight bearish bias. This is for an investor who is worried about the downside. You’ll make more money on the downside if you stay above the buffer.

“Even if you don’t, you’ll outperform the Russell because you’re buffered. At least you’ll outperform by the buffer minus dividends. The key is you can’t be ultra-bearish.”

At first glance, moderately bullish investors stand to profit from the structure, he said.

But even for that camp, the payout might be too limited.

This adviser assumed a hypothetical digital return of 18%, which is on the higher end of the 16% to 19% range. Such figure would represent a 5.67% annualized compounded return.

“If you expect 5.67% a year from the Russell, you’re not terribly ambitious. The upside is limited even for a mildly bullish investor. Perhaps that’s the problem with this note,” he said.

Rebalancing the payout

Rather than a negatively skewed payout, this adviser said he would prefer to see more upside potential and get a more balanced probability of profit on both sides of the trade.

“I’d rather have a 10% annualized return on the upside even if it means only a 10% buffer on the downside,” he said.

“For investors, 10% in annualized return is the historical norm. If your notes give 5.5% when the market is up 10%, your clients are not going to be happy. Clients tend to be greedy on the upside. They don’t like to do less than the market.”

With a 10% buffer on the downside and a 10% digital payment on the upside, investors would still outperform by 20 percentage points if the market were to drop 10%, he explained. The buffer would enable them to outperform as well for losses in excess of 10%.

“The downside would be covered and the chances of outperforming the Russell in an up market would be greater,” he explained.

New normal

Since volatility picked up last summer, advisers and money managers have lowered their equity return expectations. The so-called “new normal” expectation – the term refers to market conditions after the financial crisis – would be more in the 5% to 6% range, he said. But even at these levels, the digital cap range as described in the prospectus would barely allow investors to beat the benchmark, he noted.

“You’re not even talking about moderately bullish. It’s more like someone who has a range-bound view of the market, almost a flattish view on the upside,” he said.

“Even though you have this new normal mindset, whatever you want to call it, pensions and endowments don’t have such low outlooks. They tend to expect 7.5% a year, and that includes both bonds and equity. They’re lowering their expectations looking forward because you can’t get 5% on bonds right now. But equities are supposed to do better than that.

“This note is more geared towards conservative investors. It’s for clients who are extremely cautious.”

And while some of his clients are certainly cautious, the risk-adjusted return of the product had little appeal for him.

“I wouldn’t use it because the cap is too low. The upside is just too limited for us,” he said.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on May 25.

The Cusip number is 17324C3B0.

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