Citigroup’s market-linked securities on best of two baskets show innovative structure

By Emma Trincal

New York, May 15 – Amid a flurry of worst-of deals, a treat for advisers is the opposite trade: best-of options embedded in structured notes.

So far, the main issuers in this category of products have been HSBC and Citigroup. Sizes are usually small; costs tend to be expensive.

Citigroup Global Markets Holdings Inc. plans to price a new issue of market-linked securities due May 22, 2024 linked to the best performing of two baskets, one focusing on Japanese equities and one focusing on bonds, according to a 424B2 filing with the Securities and Exchange Commission.

The Japanese equities-focused basket consists of the Nikkei 225 index with a 65% weight, the iShares 20+ Year Treasury Bond ETF with an 8.75% weight, the iShares Core U.S. Aggregate Bond ETF with an 8.75% weight and the price of gold with a 17.5% weight. The bond-focused basket assigns the Nikkei 225 index with a 17.5% weight, the two bond funds with a 32.5% weight each and gold with a 17.5% weight.

The payout at maturity will be par plus at least 127.75% of any gain of the best-performing basket. Investors will be exposed to any decline in the best-performing basket.

Buysiders want more

“We don’t see many best-of in this market because they’re very expensive. Clients love it though,” a market participant said.

“With this one, you’re only getting 65% of the best-of. It would be better to have 100%. But this structure gives you 1.27x leverage.

Compared to a long-only portfolio with a 65% and 35% static exposure, investors in the notes will enjoy greater flexibility.

“You also have the upside leverage and no negative leverage,” the market participant said.

Strategic dilemma

The deal was the response to a reverse inquiry from a buysider looking for exposure to the Japanese equity market. Part of the strategy was to address the challenge of timing a recession at this later stage of the bull cycle.

“Every strategist predicts a recession within the next five years. How do you make any investment decision or allocation when you have no idea if the recession will happen in 12 months, 24 months or three years from now? Nobody has a crystal ball,” this market participant said.

“This note is a lookback giving you the better of the two baskets. It’s the better of either Japanese stocks or bonds.”

The bond component is designed to reduce volatility in a down market while the bet on Japan reflects the investor’s view on this part of the world.

“You can take advantage of a bull market in Japan while you’re hedging your downside if there’s a recession,” the source said.

Tax savvy

The structure may also appeal to asset allocators trying to minimize taxes for their clients.

A typical asset allocation requires frequent rebalancing, which leads to much buying and selling. Tax liabilities occur when capital gains are realized.

“The structure will switch the allocation for you with the lookback. It’s more tax-efficient if you compare it with a static basket,” the market participant said.

One in a series

The Citigroup upcoming best-of on two baskets is not the first one from this issuer this year.

Citigroup priced $1 million in February and another $1 million in April. Another $1 million deal came out at the end of December.

Those previous deals however were slightly more complex. Each of the two baskets consisted of four equity indexes, four bond indexes and two commodities components.

“The new one is only Nikkei as equity and it’s far simplified in number of reference assets,” he said.

HSBC Allocator

HSBC USA Inc. has also offered its own version of best-of structures under its “performance allocator” label.

Its most recent deal came out last month as $2.1 million of three-year notes linked to three baskets of regional indexes.

The U.S. basket included the S&P 500 index and the Russell 2000 index. The Europe basket consisted of the Euro Stoxx 50 index and the FTSE 100 index. The Asia Pacific basket was made of the S&P/ASX 200 index and the Nikkei 225 index.

Each index had a 50% weight within its respective basket. The payout was the allocated return of the baskets, which was calculated based on a specific formula giving a 50% weight to the best performing basket, a 30% weight to the second best and a 20% weight to the worst. Investors received the allocated return benefiting from a 15% buffer on the downside.

Eggs and baskets

The Citigroup structure differs from the HSBC in the organization of the underlying baskets. With the Citi notes, the two baskets share the same components. Only the weightings vary. In contrast, HSBC’s “allocator” showed different indexes but fixed weightings.

“The HSBC is more disperse than Citi,” the market participant said.

This difference between the two structures impacts pricing. Best-of call options are short correlation. The best outcome for investors is when the underliers start with high correlation but end with increased dispersion.

“When the assets are uncorrelated you should see higher returns. The HSBC way is probably more expensive,” he said.

“Here you get the best two of three similar components. They’re the same in each basket. If they’re uncorrelated, it doesn’t matter. You’re either going to get 65% in Japanese stocks or 65% in bonds.”

The whole purpose was to offer a bullish vehicle for the Japanese stock market with less volatility through bonds.

“If the Nikkei does well, you get 65% of it. If we have a recession in the next five years and bonds outperform, you’re guaranteed the 65% in fixed.

Cross assets diversification

One factor that facilitated pricing was the fixed allocation to gold. Whether the best basket turns out to be the Japanese equity-focused or the bond-focused, investors will get an unchanged allocation of 17.5% to the commodity.

“It’s a cheaper structure overall for those who want more upside and are willing to be exposed to the downside risk.”

The presence of commodities in the baskets grabbed the attention of a portfolio manager who has invested in best-of deals before.

“What I really like about this one as opposed to previous ones I’ve seen is that it’s not just a pure equity play. You have some good diversification across stocks, bonds and commodities.”

The notes are guaranteed by Citigroup, Inc.

Citigroup Global Markets Inc. is the agent.

The notes will price on Friday and settle on May 22.

The Cusip is 17326YR81.

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