Citigroup’s $2.21 million digital notes linked to Russell 2000 show disappointing risk-reward

By Emma Trincal

New York, June 6 – Citigroup Global Markets Holdings Inc.’s $2.21 million of 0% enhanced buffered digital notes due May 31, 2019 linked to the Russell 2000 index enable investors to outperform the index in a mildly bullish or bearish scenario, but investors are not getting adequately compensated for the risk they are exposed to, according to financial advisers.

The notes are guaranteed by Citigroup Inc., according to a 424B2 filed with the Securities and Exchange Commission.

If the index finishes at or above its initial level or falls by up to the 15% buffer, the payout at maturity will be par plus the fixed return of 16%.

Otherwise, investors will lose 1% for every 1% decline beyond 15%.

Risk

“This one is an interesting one, but it’s hard to make a determination,” said Jerrod Dawson, director of investment research at Quest Capital Management.

Getting a positive return if the index declines by up to 15% is the “interesting” aspect of the deal, he said.

On the other hand, investors in the three-year note are capped at 16% on the upside, he noted, which is about 5.35% a year.

Despite the possibility of outperforming between those two points, the risk is too high, in his view.

“A 15% decline in the Russell wouldn’t be that uncharacteristic,” he said.

“I’d like to buy a protection like that after more of a pullback.

“The Russell is not particularly cheap right now, and the odds of a more than 15% drop are not that far off.”

Even if the small-cap benchmark was “at fair value,” Dawson would still not be comfortable with the size of the buffer given the underlying volatility of the index.

Risk-adjusted return

“You’re not being compensated for the risk you’re taking,” he said.

He compared the return offered by the notes with a straight corporate bond. A three-year Citigroup corporate bond was yielding 1.85% at mid-day on Monday. Investors in both the bond and the structured note share the credit risk exposure, he said. But principal is returned to the investor with the corporate security regardless of the market moves while up to 85% of principal may be lost with the structured note, he said.

“Of course the Citi corporate paper pays very little, but you get par back at maturity. Here, you’re getting a premium, but your return is only 5.3% a year and you have a bigger downside,” he said.

“You’re not getting compensated for the risk you’re running.”

Dawson said he was not sure he understood the market view of investors in the notes.

“If you’re bullish, you don’t like it because you’re not going to participate. If you’re a bit bearish, you’re not going to like it either because it doesn’t offer that much protection.”

Credit, fee, cap

Michael Kalscheur, financial adviser of Castle Wealth Advisors, had a similar view.

Kalscheur said he was comfortable with the issuer’s credit risk. Citigroup Global Markets Holdings is a subsidiary of Citigroup with the same credit rating. The long-term debt is rated BBB+ by S&P.

But some of the terms are “disappointing,” he said, such as the fee amount of 3% and the cap.

“One percent a year ... That fee is pretty expensive, and I wouldn’t be happy with that,” he said.

“The 15% buffer is better than nothing, but it’s the low cap that really gets me. If you’re going to limit your upside that much, you should have more protection.”

The 15% buffer is not sufficient based on the underlying volatility of the index, he said.

The relatively short duration is also a risk factor, in his view.

“I would like a 15% better over a longer timeframe, five-year or more,” he said.

“If you have to keep the term to three-year, a 15% would be fine but on the S&P.”

The fact that the digital return could be gained even if the index is negative as long as it stays above the 85% threshold does not do much to change the risk-adjusted return, he added.

“The absolute return with the digital return, I understand that it’s a benefit.

“In that case, the market is down 15%, you’re up 16%. That’s pretty good. But it can’t get any better than that.”

Statistically speaking

Kalscheur looked at the risk-return probabilities over the past 30 years based on three-year trailing periods from statistical history he compiled on this index.

He found that 10% of the time, the Russell 2000 had dropped more than 15%. On the upside, the odds for investors to get “capped out,” or to see the index rise by more than 16%, were 70% of the time, he noted.

“The only chance you have to outperform is when the index is between minus 15% and plus 16%. It’s between those two points that you can significantly beat the index. That’s the outcome you want.”

In terms of statistics, there was only a 20% probability for this desirable outcome to take place.

Getting paid only 5.3% a year when the odds of a positive scenario are limited to 20% does not seem like a good risk-adjusted reward, he said.

“I can’t get excited with 5% on that index,” he said.

“If you’re going to cap to that degree, why get into equity?

“I can get a 6%, 7% or 8% on an aggressive bond portfolio.

“There are more conservative things than equity that I can do in order to get more.”

The notes (Cusip: 17324C3B0) priced on May 25.

Citigroup Global Markets Inc. was the underwriter.

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