Citigroup’s notes tied to Citi Dynamic Asset Selector 5 to offer bond-like instrument

By Emma Trincal

New York, June 8 – Citigroup Global Markets Holdings Inc.’s 0% market-linked notes due June 20, 2025 linked to the Citi Dynamic Asset Selector 5 Excess Return index can be used to smooth volatility in a portfolio and supplement a bond allocation, advisers said.

The payout at maturity will be par plus any index gain. If the index finishes flat or falls, the payout will be par, according to a 424B2 filing with the Securities and Exchange Commission.

“Even though I’m not a fan of proprietary indices I would do it. There’s a real need for principal-protection in this environment,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“This market had such a run since March, this is a house of cards.

“It’s looking for an opportunity to fall.”

Needed hedges

The S&P 500 index has jumped by more than 47% since its low of March 23 when it just began to rebound after a 33% drop off its February high. The benchmark is now flat for the year.

Kunhardt said that as a result of the current upward momentum some investors have been itching to join the rally.

“I spend a lot of my time trying to discourage clients to jump in, warning them the market could rapidly move the other way,” he said.

What is beginning to look like “irrational exuberance” requires caution and hedging, he said.

As an example of the disconnect between the market and earnings, Kunhardt pointed to a chart plotting the Nasdaq-100 performance and the consensus 12-month forward earnings-per-share for this index. Since March, he noted, the correlation between the two factors became inverted with the forward EPS collapsing and the index performance soaring.

“Historically earnings and stock prices should move together. If they don’t, we’ll either have a surge in earnings or prices are going to fall, which seems more likely,” he said.

Trend-following

The notes offer principal-protection. But the index itself has a low-volatility feature built in.

The Citi Dynamic Asset Selector 5 Excess Return index is a trend-following rules-based index that seeks to identify current U.S. equity market conditions as falling within four possible market “regimes” based on trend (upward or downward) and volatility signals (above or below 15%).

Each day, the index allocates between S&P 500 Futures and 10-Year U.S. Treasury Note Futures based on the observed market regime.

A market regime characterized by falling stock prices and higher volatility will trigger a greater exposure to Treasuries and a reduced allocation to S&P 500 futures.

Inversely, rallies coupled with low volatility will expand the equity allocation an reduce the Treasuries exposure, according to the prospectus.

This rebalancing is designed to maintain an annualized volatility target of 5%.

Bond substitute

For Kunhardt, the two most appealing aspects of the deal were the principal-protection and the simplicity of the structure.

“I would consider it but as a bond instrument,” he said.

“You’re not allocating to the S&P. You allocate to equities and Treasuries, but the overall return is sort of a bond-type of return because the volatility is limited, and you have the principal-protection. So even though it does not pay income, it would go to the bond allocation of the portfolio.”

The return of the Citi Dynamic Asset Selector 5 Excess Return index so far this year is 2.6%.

“This is an instrument that’s between cash and bond. You still have credit risk, so it’s not the same level of safety as cash. But it’s also not the same risk as debt.”

Understanding the index

Investors however would have to be comfortable with the index.

“When you show this type of instrument to a client you don’t spend most of your due diligence on the note. The note is very straightforward. One-to-one on the upside, 100% principal-protection on the downside. But you do have to understand the index. Not the algorithm itself but how it’s constructed.”

“For instance, it’s 5% volatility target. But how is the 5% volatility target calculated? You have to look at the prospectus very carefully. Sometimes things are explained in there. Sometimes they’re not,” he said.

“We have to send the offering to the client and make sure they understand. The due diligence process with proprietary indices is not always straightforward.

“But if the adviser and the client are both comfortable with the index, this is a nice fixed-income substitute.”

Bond-like solution

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the notes could solve some of the issues faced by bond investors.

“It looks like a security that provides bond-like exposure but better performance than bonds,” he said.

“A lot of people are looking for bonds, and it’s understandable.

“People buy bonds to add safety, produce income and offset equity risk in a portfolio.

“The problem with fixed-income investments right now is that they no longer generate income. Yields are too low. In addition, they don’t always diversify equity risk.

Appealing

“Something like this, a little bit different, may appeal to people looking for some of the positive effects of bonds in a portfolio, which you can no longer get so easily.”

Not getting any income was not a big drawback.

“You’re not missing much given the level of interest rates,” he said.

“The full principal protection and the uncapped upside are what makes the note appealing.”

The only “downside” for Chisholm was the “illiquidity” of the product, a negative that applies to most structured notes in general and which Chisholm is not always comfortable with.

“The fact that you can’t redeem it immediately like a listed security is still a big challenge to me especially in this market, which changes so quickly.

“But the note definitely has some appeal,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes will price on June 17.

The Cusip is 17328VL40.

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