Citi’s autocall contingent coupon notes on three stocks offer eye-catching coupon for a reason

By Emma Trincal

New York, March 11 – Citigroup Global Markets Holdings Inc.’s autocallable contingent coupon equity-linked securities due March 31, 2022 linked to the worst performing of the common stocks of American Airlines Group, Inc., Nvidia Corp. and Twitter, Inc. pay an unusually high contingent rate, which is not a surprise given the risks associated with the structure, sources said.

The notes will pay a contingent quarterly coupon at an annual rate of 18.35% if all three underliers close at or above 50% of their initial level on the valuation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

Beginning in June and ending in December 2021, the notes will be called at par plus the contingent coupon if all three underliers close at or above their initial level on any quarterly valuation date.

The payout at maturity will be par plus the final coupon unless any underlier finishes below the 50% final barrier value, in which case investors will receive a fixed number of shares of the worst performing underlying equal to its equity ratio or, if Citigroup prefers, the cash value of those shares.

A financial adviser looked at the three stocks first, pointing to the risks.

Roller coaster

“Nvidia and Twitter have been extremely volatile in and of themselves.” said Scott Cramer, president of Cramer & Rauchegger, Inc.

“If you look at the chart of Nvidia, it looks like the Incredible Hulk Coaster.”

After hitting an all-time high of $292.17 in October, the share price dropped 57.5% on Dec. 24 to $124.33.

From August 2015 to the October high of last year, the stock gained 1,361%.

“Both Nvidia and Twitter can easily drop 30% within three years,” he said.

In addition, investing in Twitter means facing “business uncertainties,” he added.

“Twitter is exposed to regulatory changes. The company could be highly regulated.

“If it turns out that Twitter has privacy issues like Facebook, they could have investors leave en masse.”

The industrials sector was not immune to challenges.

“If we have a recession, American Airlines is going to go down. You’re taking recession risk,” he said.

Easily breached

For Cramer, the 18% coupon was not surprising given the risks he mentioned.

“18% is a lot. But you’re not talking about a typical income product,” he said. Neither the coupon nor the principal were guaranteed, he noted.

“You may have a 50% barrier but it’s not necessarily that much of a protection given the high volatility of the underlying. We’ve seen some of those stocks breach the 50% threshold and drop even more in less than three years.

“I don’t think it’s worth the risk.”

Low correlation

A structurer not affiliated with Citigroup explained that the pricing of the deal was probably logical and sound. It’s the investor’s outlook that ultimately will determine whether the risk is worth taking.

He first explained how it was possible to generate a nearly 20% contingent coupon.

“Most worst-of we see are on equity indices with correlated indices. But in order to get higher yield people have to move away from indices and use individual stocks. That’s one reason they can enhance the yield,” he said.

“Those three names are probably not correlated. You have airlines, social media and technology, three different industries. So obviously there is dispersion risk.”

Dispersion is the opposite of correlation.

“When the stocks are correlated, if one does well, they tend to all do well,” he said.

“When there is dispersion, two stocks could do well but the third is not going to do well. That’s a risk, which gives you the higher coupon.”

Naturally the contingency of the coupon was another factor, as well as the automatic call feature. But those are common to this type of product.

Barrier at first sight

One alluring feature of the structure was the apparently low barrier.

He explained that trying to gauge the value of a barrier “at first glance” is a vain effort.

“You can’t tell how good the barrier is. You’d have to compare the notes with a similar deal being priced at the same time with the same underlying stocks, the same issuer, the same maturity, which is impossible,” he said.

For this issuer, most deals are fairly priced because “it’s just math.”

“All banks use the same models and the probabilities based on specific terms don’t vary. They only change when you modify the terms,” he said.

It’s all relative

Barrier levels are relative, he added.

“The lower the barrier, the less likely you lose. The higher the barrier, the more likely you lose. But of course, your probabilities of losses depend on a great number of factors,” he said.

“Once you know the probabilities of breaching the barrier, you can calculate the coupon. If you have a 40% chance of getting your coupon, you’ll get a higher coupon than if your probability is 70%.

“Regardless of which bank runs the model, the probabilities never change if you plug in the same factors. They depend on a set of terms, which you can modify. But to say that 50% is better than 70% is non-sense. Correlations, volatilities and many other parameters have to be included in the formula.”

No symmetry

Investors when assessing a note should also compare its payout with a long position in the underlying.

This structurer noted that autocallable contingent coupon notes are sometimes criticized for their risk return profile. Namely, the notes in this case pay a maximum 18.35% annual return but investors may lose 100% of their principal.

“We hear it a lot. Some [registered investment advisers] say that it’s asymetrical. Why is my upside capped at 18% when I can lose all my money?” he said.

“The fact that it’s asymetrical doesn’t make it a bad deal. In fact, most structured products deals are asymetrical. “They give you outcomes you could never get by buying the stock. How else are you going to get paid 18% if the market stays the same or if it drops? How else can you earn 18% even if the stocks end up losing half of their initial value? There is no equivalent to that if you’re long the stock.”

Even with some bonds, which provide full return of principal, investors remain exposed to credit risk.

“Take high-yield bonds. You can lose your entire principal and get paid a high yield. Isn’t that asymetrical?

“If you think everything has to be symmetrical, you’re not in the right game,” he said.

Investor’s view matters

Conviction is another important element, according to this structurer, because ultimately the market outlook of the investor will determine the decision to buy or not to buy a product.

“The probabilities of outcome are always the same. What’s different are the views. If everybody had the same views, there would be no trade.”

For this product, investors had to be “slightly bearish” and could not be too bullish, he said.

“It seems like a fair deal to me if you’re more risk-seeking. High nominal rates mean more risk because banks are not giving money away. The expected return is lower than 18%; otherwise, the deal wouldn’t price. You’re just hoping to beat the odds. Hopefully you’re luckier than the bank that sells it to you,” he said.

He explained what he meant by “luckier.”

“Your view is more positive than whatever the expected return should be. If you’re lucky, you make money. I use the word luck because that’s what it means: if your view turns out to be better than what the probabilities say, in layman’s terms, you’re lucky.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 17324XES5) will price on March 26 and settle on March 29.

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