Citi’s two worst-of issues show analogous yields, yet different underlying, risk, call terms

By Emma Trincal

New York, May 3 – Citigroup will price two contingent coupon note issues tied to the worst of two assets, showing differences in the choice of underliers, the type of call options and their respective tenors. Yet sources pointed to the similarities in contingent yield and barrier levels.

The first deal is linked to index funds, tracking the broader market, while the second one is linked to single stocks.

Worst-of on ETFs

The notes for the first deal are callable at the issuer’s discretion on any quarterly determination date.

Citigroup Global Markets Holdings Inc. plans to price 0% callable contingent coupon equity-linked securities due May 26, 2022 linked to the worst performing of the Invesco QQQ Trust, Series 1 and the SPDR S&P 500 ETF Trust, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a contingent quarterly coupon at an annual rate of 7% if each asset closes at or above the coupon barrier price, 80% of the initial price, on the valuation date for that period.

If the notes are not called, the payout at maturity will be par unless either asset closes below 80% of the initial price, in which case the payout will be the value of the worst performer from its initial level in shares or cash, at the issuer’s option.

Worst-of on stocks

The second deal, six-month longer in maturity, is linked to two big tech stocks. The notes are automatically called quarterly if both stocks close at or above their initial level on any quarterly determination date.

Citigroup Global Markets Holdings’ autocallable contingent coupon equity linked securities due Dec. 1, 2022 linked to the worst performing of Apple Inc. and Microsoft Corp. will pay a contingent coupon at an annualized rate of 8% if the worst performing stock closes at or above the barrier price, 78% of the initial price, on the valuation date for that quarter.

The barrier at maturity is set at 78% as well. If breached, investors will be “long” the worst performing stock either in shares or cash, at the issuer’s option.

Mildly bearish

“There’s a lot more volatility with Apple and Microsoft than there is with the broadly diversified S&P 500 and Nasdaq,” a financial adviser said.

“That means Apple and Microsoft could go down more than 22% easily. They can also go up a lot more. You’re not going in there if you expect a lot of upside from big tech.”

Both notes represent a common view on the market.

“It’s OK if it goes down a little bit but not below a certain point. If it goes down too much, you’re getting zero coupon, or you lose money at maturity. If it goes up too much, you’re called with one coupon and the deal is terminated,” he said.

“What you do is buy a little bit of insurance if you don’t believe it’s going to drop a lot.”

Call

This adviser did not view any of the two call options favorably.

Part of the reason is the fee, which is priced in the structure.

“If it gets called right away, it’s a money loser because you paid the commission upfront,” he said.

The level of correlation was a factor in reducing the chances of a call.

“If the assets have a low correlation, there’s a lower probability that you’ll get called. But there’s also a higher probability that you will end up below the barrier with zero coupon or some loss of principal at maturity. The chances of a positive outcome are lower,” he said.

To buy either one of the notes, investors need to believe in two things, he said.

“You think the underlying are correlated and will stay correlated. You’re long correlation. That’s one. Second, you need to be slightly bearish. The only time you’re in a good position is when the worst-of is going down but not too far down,” he said.

Disparity of returns

When comparing the two deals, this adviser said the notes tied to the single stocks may not pay enough premium in comparison with the other deal.

“There is more risk in the notes linked to Apple and Microsoft,” he said.

“Those stocks are more volatile than the Invesco QQQ and the SPDR S&P ETF.

“There’s also less correlation between the two tech stocks.”

Correlation differences

The implied volatilities of Apple and Microsoft are 27% and 24%, respectively, compared to 20% for the Invesco QQQ Trust and 17% for the SPDR S&P 500 ETF.

More telling is the differences in correlations when comparing the deals. The two ETFs have a one-year correlation of 0.839 versus for the other note, 0.635 between the two stocks.

“The lower the correlation, the greater the risk. Imagine a correlation of zero, it would be a horrible deal. You would get one or another, which is not good for a worst-of. Ideally, you want a correlation of one,” he said.

Thin spread

Given that the stock deal presented more volatile underliers with a lower correlation to one another, this adviser was surprised that investors would only get 1 percentage point more in yield (8% versus 7%) at quasi-identical barrier levels, the riskier deal offering 2 percentage points of extra protection.

“8% is not enough to compensate you for the added risk you take betting on Apple and Microsoft if you think purely in terms of correlation,” he said.

“The fact that the stocks are more volatile than the ETFs also adds risk, which is not reflected in the coupon in my view.

“It just seems like the spread between the two is not enough. You should get more than 8% on the note linked to the single-stocks.”

Another factor making the small difference in yield even more surprising was the lower cost per annum for the single-stock notes with a 1.25% fee over 18 months (0.83% per annum) versus 1% for the ETF-linked notes carrying a 1% fee on a one-year tenor.

On the other hand, other variables were at play in the pricing, such as the longer maturity for the stock deal. Short-dated notes may price better with payouts structured around short volatility positions, such as income deals.

Another point was the automatic call used in the stock deal versus the issuer call employed with the ETF-based product, the former being more expensive to price.

Market proxies

Carl Kunhardt, wealth adviser at Quest Capital Management, saw little difference between the two offerings and was not sure which one he would be more inclined to consider.

“I’m actually surprised that the correlation between Apple and Microsoft is not higher. To me, they’re almost a proxy for the market.

“If you ask me whether Apple is going to be higher in 2022, it’s a no-brainer. It will be. Same thing for Microsoft. It’s a pretty definite answer, the same type of answer I would have with the broader market,” he said.

Apple and Microsoft are the two top holdings of the SPDR S&P 500 ETF, making for more than 11% of the fund. For the Invesco QQQ Trust, both stocks also top the list as the largest constituents, accounting together for 20% of the portfolio.

Company risk

On the other hand, Kunhardt was not surprised to see both underlying stocks more volatile than the ETFs.

“Anytime you have two different companies, you’re obviously going to take on more risk than if you bet on an index or ETF, which are by definition more diversified,” he said.

The Invesco QQQ Trust, Series 1, which replicates the Nasdaq-100 index, has 100 constituents, he noted, while the SPDR S&P 500 ETF Trust tracks the 500 stocks in the benchmark.

“In both deals, you’re going to get paid the coupon. You’re not going to get any appreciation.

“The one-year or 18-month timeframe is irrelevant.

“The fact that one is callable and the other autocallable makes very little difference.

“You’re picking up a little bit more risk on the single stocks. But you’re getting 1% more in coupon,” he said.

On the fence

Kunhardt was unsure about the deal he would be inclined to pick if any.

“If I’m more aggressive, I would go for the Apple/Microsoft one. If I want to make a play for diversification, I would go for the indexes.

“But Apple, Microsoft and the Nasdaq are engines of growth. Both notes are positioned for yield rather than growth, which sounds like an oxymoron.

“I guess I’m sort of ambivalent. There’s nothing there that grabs me but nothing that pushes me away either,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter on both deals.

The notes linked to the ETFs (Cusip: 17328NPV4) will price on May 21 and settle on May 26.

The notes tied to the two tech stocks (Cusip: 17328NPT9) will price on May 27 and settle on June 2.

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