Citi’s $1.21 million callable contingent coupon notes on three funds offer ‘pretty good’ trade

By Emma Trincal

New York, June 30 – Citigroup Global Markets Holdings Inc.’s $1.21 million of callable contingent coupon notes due June 28, 2022 linked to the Financial Select Sector SPDR fund, the SPDR S&P Bank ETF and the SPDR S&P Regional Banking ETF intrigued advisers for its double-digit coupon and perceived limited risk given a low barrier, high correlation between the underliers and depressed market prices.

The notes will pay a contingent quarterly coupon at an annualized rate of 12.5% if each asset closes at or above its coupon barrier, 55% of its initial level, on every day that period, according to a 424B2 filing with the Securities and Exchange Commission.

After six months, the notes will be callable at par quarterly.

If the notes are not called and the final level of each asset is greater than or equal to its 55% final barrier level, the payout at maturity will be par plus any contingent coupon due. Otherwise, investors will be fully exposed to the decline of the worse performing asset.

Correlations

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said he liked the risk-adjusted return of the product.

“This is an interesting note. I don’t do a lot of income products, but this one gets my attention,” he said.

The first attractive aspect of the structure was the high correlation between the underliers.

The three ETFS are almost perfectly correlated, he noted. The lowest correlations are seen between the Financial Select Sector SPDR fund and the SPDR S&P Bank ETF (one-year coefficient of correlation of 0.968) and between the Financial Select Sector SPDR fund and the SPDR S&P Regional Banking ETF (0.961 coefficient).

Still, those correlation levels are extremely high, he noted.

“It’s the Financial Select that is a little bit less correlated because its top holding is Berkshire Hathaway, which is classified as financials due to the company’s insurance holdings,” he said.

Berkshire Hathaway Inc. is the top holding in this fund with a 13.5% weighting.

Even though the barrier conditions apply to the worst of three assets, the nature of the underlying securities is somewhat defensive, he added.

“These are concentrated sector funds, but they are still funds. They’re not stocks. And they’re very highly correlated to each other. They’re all in the financial services, mostly in the banking arena.”

High yield

Kalscheur said the 12.5% coupon was compelling not just due to its size but in relation to the barrier level, setting the conditions to receive the payment and get principal repayment at maturity.

“Looking at those three different funds, we think it’s unlikely any of them would go down 45%,” he said.

This was due to two factors: the currently depressed prices of the ETFs and the fact that the barrier was significantly low based on the price action seen in March, when the market crashed, and the funds bottomed.

The SPDR S&P Bank and the SPDR S&P Regional Banking are up 40% from their March lows. But they’re still “considerably below” their levels of January, he noted.

Safe margin

Both funds are approximately down by a third for the year.

The Financial Select Sector fund is up 32% from March but remains down 25% for the year.

“I haven’t done any analysis or back-testing on these three ETFs. But if you look at the barrier levels in the SEC filings, you’ll see that a lot of the risk has already been taken off the table,” he said.

The coupon barrier and barrier at maturity is $13 a share for the Financial Select Sector SPDR fund, $17.76 for the SPDR S&P Bank ETF and $21.48 for the SPDR S&P Regional Banking ETF, according to the filing.

“Those barrier levels are far below what the lows of March were,” he said.

Any of those funds would have to drop at least 21% from their bottom price at the time, he noted.

“It’s not anywhere close. I don’t see that happening within the next two years,” he said.

Yield enhancement

The nature of those structures is to provide income, he added, not to participate in the upside. An ideal scenario would be a range bound market with the price moving between 55% and 112.5%.

“I wouldn’t take a bet that the sector will outperform the market. But that’s not what we’re betting on.

“As long as none of the ETF is down by more than 45%, you’re going to get paid. You would have to be significantly lower than the worst of March to breach those levels.

“This barrier and the share price of those funds make me confident that you’re going to get paid. It’s not a guaranteed coupon. But the barrier is strong enough.

“I’m also reasonably confident that the chances of losing money at maturity are low,” he said.

Six months

The risk of being called is another aspect to consider especially with this note, whose call feature is not automatic but at the discretion of the issuer.

“At least you have a six-month guarantee. You may be called out at that point. If that’s the case, you’re getting 6% for half a year.

“The barrier is wide enough and the coupon high enough to justify the risk and my time for this investment whether it’s a six month or a two year.

“This product is a little different. I would probably have to do a little bit more research on the sector. But it looks good.”

Juicy yield

Tom Balcom, founder of 1650 Wealth Management, also liked the note.

“You’re giving up some dividends,” he said.

The Financial Select yields 2.71%. The SPDR Bank has a yield of 4.23% and the Regional one yields 4.48%.

“But for an investor who is not sure where the market is going, this note is offering three times the best-yielding ETF.

“Will one of these three be down 45%? That’s the risk. But you already had a 30% pullback. It’s not very likely.

“Where else are you going to find a 12.5% coupon? Nowhere. The two-year treasury is a 0.15%.”

Tradeoff

Even a 6.25% return in six months if the issuer calls the notes at the earliest time would be attractive in this low-rate environment, he said.

“How else are you going to earn that yield?

“You’re getting it by having an issuer call and giving up the dividends.”

Balcom said he liked this kind of tradeoff.

“The chances of those ETF to collapse are pretty slim.

“It’s a very juicy coupon.

“There is a lot of overlap between the underlying ETFs. Correlations are high.

“It seems like a pretty good trade.

“For someone looking for yield, it’s a good alternative if not a better choice than high-yield,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Friday.

The Cusip number is 17324XP79.

The fee is 1.5%.

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