Citi’s contingent coupon autocallables on four stocks pay high coupon, but losses can be steep

By Emma Trincal

New York, June 12 – Citigroup Global Markets Holdings Inc.’s autocallable contingent coupon equity-linked securities due June 28, 2023 tied to the worst performing of FedEx Corp., Goldman Sachs Group, Inc., Micron Technology, Inc. and Visa Inc. offer a high coupon rate, which derives from the volatility of some of the underlying stocks and to a lesser degree to the use of four underliers in the worst-of, said Tim Mortimer, managing director of Future Value Consultants.

While investors get protection from a barrier at maturity and from 12 call dates, losses if the barrier is breached can be significant with this product, he noted.

The notes will pay a quarterly contingent coupon at an annual rate of 17.75% if each underlying stock closes at or above its 60% coupon barrier on the related quarterly observation date, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if each stock closes at or above its initial level on any quarterly call observation date.

The payout at maturity will be par unless any underlier finishes below its 60% final barrier value, in which case investors will receive a fixed number of shares of the worst performing underlying equal to its equity ratio or, if the issuer prefers, the cash value of those shares. Each stock’s equity ratio is equal to $1,000 divided by its initial share price.

Four names

“17.75% is a very high yield and with that come greater risk. Also 60% is quite a big barrier. There’s definitely high volatility in this product,” he said.

Four stocks rather than two or three is not as common in a worst-of, he noted.

“Some of the value comes from that. It adds something, but the gains in premium are limited,” he said.

The contingency of the coupon and the autocall also add risk therefore more premium, but those features are common to all other similar products, which may not pay nearly 18% in annual return, he noted.

Correlation

One factor affecting pricing is the correlation between the underlying stocks. The lower the correlation, the higher the coupon because the chances of one of the stocks performing poorly increase.

With this product, correlation between the four names is relatively high, said Mortimer.

The coefficient of correlation between the stocks vary between 0.94 and 0.96.

“It’s in part a result of the market. This year we’ve seen correlations rise,” he said.

Correlations tend to increase with volatility.

The presence of a fourth stock versus the more usual two or three fails to provide a significant amount of additional premium because the stocks are highly correlated to one another, he said.

“In general, when you keep adding underlying assets, you just limit your gains at some point. It’s not linear. You may get more premium but as you add more, the additional benefit becomes insignificant,” he said.

Call features

A few other elements in the structure provide issuers with more pricing power.

“There is no call protection. You can finish in three months with a 4.4% return. There is also no memory feature. If you miss a call, you can’t catch up,” he said.

“Those couple of things add value allowing for the pricing of a higher coupon.”

Volatility

But the main driver behind the high coupon is volatility, he added.

“It’s really the volatility of the stocks rather than the dispersion risk that’s at the origin of the yield enhancement,” he said.

Micron Technology and FedEx are the most volatile names with an implied volatility of 41.6% and 34.9%, respectively.

Finally, dividends are not relevant in the pricing.

“Those stocks do not carry high dividends at all. So, it doesn’t help much,” he said.

Goldman Sachs is the highest-paying dividend stock with a 0.68% yield.

“The coupon could be even higher if the stocks carried high dividends. But it’s not the case,” he said.

Stay-at-home

Investors in the notes are not buying a diversified basket, Mortimer noted, since the exposure is to the worst of the four, not their average return.

The notes however offer an investment theme based on the stock picks.

“You’re betting on a lockdown basket. It’s a play on the new economy,” he said.

“What do people do when forced to stay home? They use their credit card more; they send parcels; they day trade and buy tech stocks online and banks are always there.

“It’s quite a reasonable bet. These are defensive stocks, which could do well even if the situation drags on.”

Stress test

Future Value Consultants offers stress testing on structured notes. The Monte Carlo simulation determines the probabilities of occurrence of outcomes pertaining to a specific structure type.

Each report contains a total of 29 sections or tests, which encompass simulation tables as well as back-testing analysis.

One of those tests, the investor scorecard, is made up of a number of different mutually exclusive outcomes of product performance. It shows outcome names, probability of occurrence, average return and average duration.

Call probabilities

Investors have a 42% probability of being called on the first call date, or only three months, according to the scorecard.

“This is the highest probability and it always is with autocalls,” he said.

He observed that the chances of a call during the final year are particularly small. None of the probabilities for a call occurring at point 9, 10, 11 or 12 is greater than 1%.

Losses

In terms of capital loss at maturity, the scorecard reveals a 21% probability.

But the “tail risk” is substantial with an average loss of 52.1% if this outcome occurs.

“There is a pretty high probability of losing money. And if you do lose money, you’re going to lose more than half of your capital even though the barrier is at 60%,” he said.

Back testing

The back-testing analysis reveals that the frequency of calling is very similar to the results of the simulation, he noted.

“The difference is on the downside. If you look at the last five years, the underlying never went through the barrier.

“Over the past five years, we’ve had a very strong bull market and that’s why.”

Risk involved

Investors looking into this product would have a profile similar to most buyers of autocallable products.

But this one would probably better fit investors with a high tolerance for risk, he said.

“If this note lasts only one year and you get out with a 17.75% return, you’d be pretty happy.

“If it doesn’t call on that first year, you’ll start to be a little bit nervous about it.

“It’s like any autocall. You have to be reasonably bullish on the stocks or have a sideways view.

“But it’s quite an aggressive trade, and you have to be prepared for losses,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on June 26.

The Cusip number is 17324XL65.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.