Citigroup’s trigger step securities tied to S&P 500 fit range bound market view, sources say

By Emma Trincal

New York, Dec. 9 – Citigroup Inc.’s 0% trigger step performance securities due Dec. 31, 2018 linked to the S&P 500 index should outperform the index in a relatively flat market, sources said. But foregoing the dividends paid by the index has a cost, which ends up compressing the range in which the notes outperform the benchmark, they added.

If the index return is zero or positive, the payout at maturity will be par of $10 plus the greater of the step return and the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by 20% or less and will be fully exposed to the index’s decline from its initial level if it declines beyond 20%.

The step return is expected to be 25% to 31% and will be set at pricing.

Dividends

The S&P 500 index pays a 1.80% dividend, which means that the 7.20% return in dividends received over the four year term will not be available to the noteholders, said Tom Balcom, founder of 1650 Wealth Management.

He assumed a step payment of 25%, which represents a 5.70% annualized return on a compounded basis.

“The step pays 5.70% a year but you’re not getting the 1.80% dividend. So your breakeven is really 3.90%,” he said.

“If the index is up by less than 3.90% a year, the step feature will make you outperform the index. If it’s not, you’re better off with the index,” he said.

Narrow range

The non-payment of the dividends also had to be taken into consideration when assessing the downside exposure, he said.

“An equity investment would give you the equivalent of a 7% buffer, which you don’t have with the notes. So any index decline of less than 7% gives the equity investor an edge over the noteholder,” he said.

“In the negative range with losses between 7% and 20%, you’re outperforming the index. You stop outperforming when you breach the 20% threshold.

“Only between 7% and 20% in index losses will the noteholder beat a long-only investment.

“On the upside, you have to stay in a range comprised between zero and 3.90%.

“These are your best scenarios.

“That’s a very compressed range of wins scenarios.

“If the index is down by 5%, you underperform. If it’s down by 23%, you underperform. If it’s up 30%, you miss out on the dividends and as a result, you underperform.”

“The notes really reflect a range bound view for the S&P.”

Balcom said there was “nothing wrong” with a range bound view. But he was not comfortable with the width of the range.

“My concern here is that there are so few scenarios when it makes sense to own the notes versus the index, that I’m not really sure why you would go for it,” he said.

“If the index is down anywhere from 7% to 20% the notes make sense. But if it’s down 21%, all bets are off.

“Your probabilities of success are limited because you have such a narrow range of scenarios that work in your favor. It does not appeal to me very much. I want the odds to be in my favor, not against me,” he said.

Odd outcomes

Jonathan Tiemann, founder of Tiemann Investment Advisors, LLC, agreed, adding that the direction of the price moves and the size of the range where it outperformed gave the notes almost a bearish bias in terms of how much an investor could outperform the benchmark.

“The note offers no cap, which is a good thing. You haven’t sacrificed your entire upside. On the downside, the 80% barrier seems relatively decent,” he said.

“But when you look at your potential return compared to the index, the range of outcomes where you get a better payoff is actually pretty narrow because you have foregone the dividends.

“As soon as you breach the barrier, you’re better off with the index because the dividends would slightly reduce your losses.

“If you have a small loss, a loss lower than the dividend amount, you’re down compared to the index as well.

“And on the upside, the market can’t rise all that much if you want the step payout to beat the index.

“You come out ahead if you have a big loss of almost but not quite 20%. And on the upside, you really need the index to trade sideways. Betting that the market will be slightly up but could be down quite a lot is an odd set of outcomes.

“This note would almost have a bearish bias if you look at the wider downside range where you can profit – and that is 20% minus the dividend amount. But it’s not bearish because you don’t really gain anything from the index decline and you certainly lose from a massive decline beyond 20%.

“If I think the market is going to be down 15%, why would I want to own the market at all?”

UBS Financial Services Inc. and Citigroup Global Markets Inc. are the agents.

The notes will price on Dec. 26 and settle on Dec. 31.

The Cusip number is 17322X615.

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