Citi’s barrier notes tied to emerging markets ETF offer exposure to rallying, volatile market

By Emma Trincal

New York, Aug. 18 – Citigroup Global Markets Holdings Inc.’s 0% barrier securities due Sept. 5, 2018 linked to the iShares MSCI Emerging Markets exchange-traded fund are designed for cautious investors who believe the emerging market rally may continue or even slow down over the next two years but still need to mitigate risk, sources said.

The 1.5 times leverage and cap between 24% and 28% on the upside can help enhance return while the 80% barrier level provides 20% of contingent protection at maturity if the final share price is less than the barrier price, according to a 424B2 filing with the Securities and Exchange Commission.

The notes are guaranteed by Citigroup Inc.

EM rally

Steve Doucette, financial adviser at Proctor Financial, said he has been paying attention to the performance of the fund, which is often used as a proxy for the asset class.

The ETF has jumped 17.5% this year, recovering from its latest bearish stretch, which occurred between April of last year and January, resulting in a 42% price decline.

“We’ve allocated more in emerging markets when it was undervalued. Now I may want to look to peel that back,” he said.

The valuation of the fund in terms of price-to-earnings is still reasonable compared to the U.S. equity market, he noted. But the momentum of the rally and the volatility of the fund are red flags.

“You have in the back of your mind that we are historically in the second longest bull market ever,” he said.

The longest stretch was the 1987-2000 bull market.

Barrier

Doucette expressed concerns over the global impact of a market downturn in the United States.

“This note gives you 20% in protection, but historically when the U.S. market loses, the emerging markets lose much more. Since we’re talking about a 20% drop when we talk about a bear market, if we’re heading into that direction, and we are, I wonder if this barrier amount is enough,” he said.

The fundamentals for emerging markets remain strong, however.

“If the markets continue to go up, it’s the only place where you’re going to see excess returns,” he said.

“But you can easily see a situation where the baby gets thrown out with the bath water. ... If the markets collapse, emerging markets will get slaughtered like the rest, even more.”

Safety first

For that reason, Doucette said he would focus on risk control. He would try to renegotiate the terms of the deal if he were to consider investing in the notes.

While both the cap and leverage multiple are attractive, Doucette said he would prefer to replace the barrier with a traditional buffer even if it meant giving up some leverage.

“I would try to maintain the cap while decreasing the leverage and perhaps by reducing the size of the protection I could get for instance 15% instead of 20%, but it would have to be a buffer,” he said.

Bucket size

Before fine-tuning the note, however, the first question for him would be to reassess his allocation to emerging markets.

His core holding for emerging markets was 5%. Doucette raised the percentage to a range of 8% to 9%.

“When emerging markets sold off we increased our exposure. We may want to reduce it now if it’s up twice the S&P,” he said.

“I guess it comes down to the type of protection you get. It’s also about your view. We tend to stay away from what’s heating up, especially seven and a half years into a bull market.”

Fed indecision

The recent emerging markets bounce is driven by central banks’ easing policies, according to Win Thin, global head of emerging markets strategy at Brown Brothers Harriman & Co.

In the United States investors have begun to question the Federal Reserve’s intent to raise rates this year, he noted, a day after the release of the July Federal Open Market Committee meeting minutes, which many said offered nothing new.

“The Fed is so cautious, so worried. At first they said they would raise rates four times this year, but they’ve been pushing back. They continue to be data-dependent. It looks like we may not see a rate increase until December,” he said.

Dollar weakening

The Fed’s reluctance to raise rates is having a negative impact on the dollar, he noted. For the year, the dollar is down 20% against the yen and 5% against the euro.

Meanwhile, more countries have recently cut their rates, such as the United Kingdom, Australia and New Zealand while Japan and Europe have pursued their accommodative policies, he noted.

As central banks are pushing down interest rates, investors will continue to look for higher returns in more volatile assets.

“Risk will continue to rally. That includes naturally emerging markets,” he said.

Not a bad play

In this uncertain context, Citigroup’s structured note may be helpful for investors seeking some upside with less risk.

“It doesn’t seem that bad, to be honest,” he said.

“If you buy the fund, you’re long on the downside anyway. Here you get at least 20% in protection. If the barrier is breached, you’re not taking any excess risk compared to owning the shares.”

The 1.5 times leverage is also a plus since it only applies on the upside.

“Perhaps one issue here is the term. Two years is awfully long,” he said.

“But right now none of these central banks is going to tighten anytime soon, and that’s supportive for emerging markets,” he said.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on Aug. 30.

The Cusip number is 17324CA48.

© 2015 Prospect News.
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