Citi’s notes with averaging tied to S&P have shorter term, less than 100% upside participation

By Emma Trincal

New York, Nov. 6 – Citigroup Inc.’s 0% market-linked notes due May 29, 2020 linked to the S&P 500 index offer full principal protection with a relatively shorter duration than average for those types of products.

But the trade-off is less than 100% of the upside, which is not the most “marketable” form of pricing, especially when the structure features averaging of the index return, a structurer said.

The average index return will be the average of the index’s returns on a quarterly basis, the 24th day of each February, May, August and November during the term of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

Each return will be measured in comparison to the index’s closing level on the pricing date.

If the average index return is greater than zero, the payout at maturity will be par plus 85% to 95% of the average index return. If the average index return is flat or negative, the payout will be par. The exact upside participation rate will be set at pricing.

Stretching time

Principal-protected notes have become challenging to create in today’s low interest rate environment, the structurer explained. Principal-protected notes combine a zero-coupon bond and a call option, and when interest rates are low, the cost of the protection increases since less money is available to buy the options, he said.

When that’s the case, the most often used solution is to extend duration rather than limit the upside, he noted. Longer tenors, however, have made those products less attractive.

According to data compiled by Prospect News, only 19 equity-linked principal-protected notes have been brought to market this year through Oct. 31, for a total of slightly less than $70 million.

The duration of these products ranges from four to nine years for an average of 6¼ years, the data showed.

The only two four-year offerings were linked to proprietary indexes, not market benchmarks, and the majority of those deals were seven years and longer, according to the data.

Averaging

“These notes provide an interesting feature, which is the averaging,” the structurer said.

“It can be helpful and make the product a little bit more conservative.”

For simplification, he explained the averaging using a hypothetical example with a 90% participation rate, only three quarters and an index closing level of 110 at the end of the first quarter, 120 at the end of the second quarter and 90 at the end of the third quarter, assuming 100 is the initial level.

“You will average out those three levels for the three observations and get 106.66. The index average return will be 6.66%, and if they take away 10% of your participation, your return at maturity will be 6%,” he said.

“This example is interesting if you compare it to a point-to-point. If your final price is 90, the normal point-to-point would have been a 10% loss. You wouldn’t have felt any loss with the protection, but there would have been no gain. The averaging process on the other hand will get you a 6% return.”

Averaging is a “very common” feature, especially used for the structuring of principal-protected products, he said.

“It’s a little bit more conservative than the point-to-point. I like averaging because if the market is performing well, as you go along, you’re locking in those levels. If you have a crash, your averaging structure is not going to suffer too much because you’ve already accumulated. Of course it’s past-dependent. In some cases it may work against you,” he said.

Term and participation

But the participation rate is more “surprising,” he said.

“This part of the deal, the averaging, is pretty standard. What’s a bit unusual and surprising here is the participation rate. Generally with these averaging payouts applied to principal-protected notes, you have a participation of 100% or more. One hundred percent is the most common,” he said.

“The reason for that is that averaging mutes your return already. People don’t like to get less than 100% of the return. They generally would rather stretch the maturity. It’s easier to stretch the maturity and to give you 100%.”

The structurer added that with a 5½-year term, the product’s tenor is not that short.

“I’m not sure why they did it that way. Probably a client who didn’t want to go longer,” he said.

“My guess for pricing 100% of the upside is that a six-year should work and maybe a 5¾-year, but I don’t know the parameters that they use.

“I’d rather have a longer structure and get 100%. Most clients do too. From a marketing perspective, it’s much easier to get investors’ attention. When you give less than 100% participation, people feel you’re taking two things away from them. The first one is the averaging, which can be good in some down markets as it reduces volatility but can also reduce the return, and the second thing is you’re getting less than the full return.”

Trade-off

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he does not see the “trade-off” offered by the notes because even a 5½-year term is too long in his view despite the appeal of the principal protection.

“I like the idea of having the principal protected. I’m always reluctant to give up a portion of the equity upside when I take full equity risk on the downside,” he said, referring to principal-at-risk products with caps or coupons that limit the upside with a potential full downside exposure.

“So this part I like because the downside is fully protected here,” he said.

“But the problem is the tenor. While 5½ years may be relatively short for these principal-protected structures, it’s still a long time for us. Assuming a 90% participation, the question for us is, is the 10% haircut on the upside worth giving up liquidity and taking on credit risk? I’m not sure about that.

“Is this a better solution than buying the index and doing some calls?”

Additionally, he sees the full principal protection along with the averaging as costly.

“It would be better for me if the term was a bit shorter,” he said.

“The more data points you have, the longer the note, the better the odds of getting a positive return. Shorter would increase the risk. But at the same time, it would make the full principal protection worthwhile. As it is now, for a 5½-year note, I’m not very comfortable with the tenor. I get exposed to Citi’s credit, and I have a relatively illiquid instrument. I don’t see the trade-off. I can see the reason for doing those notes – people want principal protection, and you have to accept longer maturities if you want to do it with 100% of the upside. That’s a reason.

“But it’s not a trade-off. I could probably find cheaper solutions in the market. It wouldn’t have to be a structured note in this case.”

Citigroup Global Markets Inc. is the agent.

The notes are expected to price Nov. 24.

The Cusip number is 1730T03C1.

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