Citi’s autocall contingent coupon notes on Dow, Gold Miners provide rare buffer but long tenor

By Emma Trincal

New York, Nov. 13 – Citigroup Global Markets Holdings Inc.’s autocallable contingent coupon equity-linked securities due May 30, 2028 linked to the least performing of the Dow Jones industrial average and the VanEck Vectors Gold Miners ETF offer a buffered protection, which is unusual for this type of product, said Suzi Hampson, director of research at Future Value Consultants. The trade-off however is a seven-and-a-half-year maturity, which is unusually long, she added.

Each month, the notes pay a contingent coupon at a rate between 8% and 10% per year if each underlying close at or above its coupon barrier level, 80% of its initial level, on the observation date for that month, according to an FWP filing with the Securities and Exchange Commission.

The exact rate will be set at pricing.

The notes will be automatically called at par if each underlying closes at or above its initial level on any quarterly call observation date after one year.

The payout at maturity will be par unless any underlying falls by more than 20%, in which case investors will lose 1% for every 1% that the lesser-performing underlying declines beyond the buffer.

Twin reports

“A buffer is a better protection all things being equal. If the price drops more than 20% you will only lose what’s beyond 20% whereas you lose from the initial price when you breach a barrier,” she said.

“The term is very long. Those autocalls don’t usually have such long tenors. But putting a buffer in a note is costly. That’s probably why they had to stretch the term so much.”

She verified her assumption using the simulation model Future Value Cconsultants employs to offer stress-testing analysis to its customers.

She first ran a report on the notes as described in the prospectus, using the midpoint for the coupon or 9% per year.

Separately, she ran a second report based on a hypothetical product with an 80% barrier instead of the 20% buffer.

“To achieve the same price as the actual product I had to set the coupon at 14% which gives some indication of the cost of the buffer,” she said.

“It’s because a 20% buffer is expensive that they had to use such a long maturity. It’s hard for investors to make a decision based on the risk especially a with worst-of. But in this case, the difference between a 9% and a 14% coupon demonstrates the value of the buffer.”

Big losses

Future Value Consultants runs stress tests, which are displayed in each report in various tables. The tables show the various probabilities attached to a specific outcome.

When comparing the 80% barrier note with the 20% buffered product, the probabilities do not change, she noted.

“You have the same chances of getting called on the first call date, the same chance of losing money. That’s because whether it’s a barrier or a buffer, the probability of hitting the minus 20% level is the same,” she said.

“What’s noticeably different is the amount of losses. How much you’re going to get back...that’s what makes the difference between a buffer and a barrier.

“Needless to say, the barrier is more painful.”

Hampson compared the two reports focusing on a particular table called the investor scorecard. The table is made of different mutually exclusive outcomes of product performance. For this type of product, the main outcomes are the calls at various call dates or “points,” the probabilities of coupon payments at various dates and the total return loss.

For the total return loss outcome, investors on average will incur a 47% loss with the buffered product. With the barrier hypothetical note, the loss climbs to 61%.

“These are averages. It could be more; it could be less. And those are averages only for this particular outcome, when you have a total return loss. It’s certainly not good news either way. But you still do significantly better when you’re averaging a 47% loss versus a 61% loss,” she said.

Expensive protection

To price that buffer, the issuer had to extend the maturity significantly.

“Rates are so low... Protection is very difficult to price. Full protection, nearly impossible. In the past you were able to price capital protection on a six or seven year. But we just haven’t seen any principal-protected income product for a while. Today, this product with full guarantee of principal would give you only a 3% coupon, not 9%,” she said.

She estimated the 3% coupon size by adding the risk-free rate and the issuer credit spread.

As with any autocallable product, the most likely call is the first one, she said.

There is a 35.34% probability of getting called at point one, which is a year after pricing, according to the scorecard. From that point on, probabilities of calls decline at a rapid pace. For instance, the second call, 15 months from now, will only happen 6.75% of the time.

Base-case

These probabilities are calculated from the results of the Monte Carlo simulation under a “neutral assumption,” which is the base-case. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

The total return loss outcome, which includes all the paid coupons, has a 30% chance of occurring.

Another possible but very unlikely outcome is “full capital return” with a 1.28% probability.

“This is a situation in which your notes mature, and you don’t lose any money. You never got called. It is a very unlikely scenario,” she said.

“To get there, the underlying never got above 100. As you get closer to maturity, there’s a higher risk of losing money. That’s why you want to kick out so you can take away the capital risk.”

The one-year “no-call” may appeal to investors who get a chance to collect the coupon over a longer period prior to the call.

“The call protection gives you, the investor, more value. It costs the issuer more to pay over one-year period than over a three-month period. As a result of this, the call protection may decrease the coupon a bit,” she said.

Four market sets

Four distribution assumption sets are included in Future Value Consultants’ reports in addition to the neutral scenario. They represent four market scenarios, which are based on volatility as well as different growth rate assumptions. Those sets are the bull, bear, less volatile and more volatile.

The breakdown into different market types helps provide a more granular assessment of the risk. Yet, the firm’s methodology is conservative in its growth assumptions for each of the four market types.

“We are not trying to predict the market. But we offer different sets illustrating how certain market conditions may impact the outcome,” she said.

As an example, the call at point one will happen 44.24% of the time in the bull market versus 26.09% in the bear market.

Volatility and dispersion

Another interesting result, she said, was the similarities of probabilities between the neutral (35.34%), less volatile (35.89%) and more volatile (34.69%) scenarios when it comes to the occurrence of the first call.

“The reason is rather straightforward: this product is not particularly sensitive to volatility,” she said.

“It’s much more a function of how the underlying are correlated and whether they stay above the protection threshold.

“Volatility is not the biggest factor.”

The risk of divergence is relatively high given the 0.74 correlation between the two underlying which is relatively low, she said.

Not surprisingly, the chances of losses vary greatly between the bull and the bear assumptions with probabilities of 16.48% and 46.88%, respectively. Again, those probabilities are the same in both reports regardless of the nature of the protection whether it be a barrier or a buffer.

Long-term investors

In conclusion, she said the notes offer a valuable risk mitigation in reducing potential losses.

“It may appeal to conservative investors although one needs to be comfortable with a seven-and-a-half-year term,” she said.

Even though the duration is likely to be shorter due to the call option, investors should always assume that they will be holding the notes to maturity, she noted.

“The 9% coupon is quite high. The 20% buffer, generous. You have a fairly good chance of getting your coupon and also of calling.

“You just need to be comfortable holding the notes for such a long time,” she said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on Nov. 24 and settle on Nov. 30.

The Cusip number is 17328WSS8.

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