Citi’s callable notes on indexes show unique play with worst-of contingency, floating rate

By Emma Trincal

New York, Feb. 13 – Citigroup Global Markets Holdings Inc. is coming up with a novel structure designed to enhance returns. But some see too much complexity in the deal.

The issuer plans to price floating-rate trigger callable contingent yield notes due Feb. 28, 2029 linked to the least performing of the S&P 500 index, the Nasdaq-100 index and the MSCI Emerging Markets index, according to a 424B2 filing with the Securities and Exchange Commission.

The structure is unique, sources said, as it brings another element of unpredictability into the mix: the coupon is not just variable, it is also contingent. In addition, at its sole discretion, the issuer can call the notes quarterly after one year. Finally, coupon payment and principal repayment are based on the worst of three underlying equity indexes.

The notes will pay a contingent quarterly coupon at a floating coupon rate if each index closes at or above its 50% coupon barrier on the valuation date for that quarter.

The floating contingent coupon rate will be Libor plus a spread of between 380 basis points and 400 bps, subject to a minimum interest rate of 0% per year.

The payout at maturity will be par unless any index finishes below its 50% downside threshold, in which case investors will lose 1% for each 1% decline of the worst performing index.

A lot for one deal

“Wow. Three indices with limited correlation, a Libor play, 10-year maturity and issuer’s callable...I see too many moving parts here,” a market participant said.

“People do plenty of fixed-to-floater. But I haven’t seen a floating rate with also the contingency.

“That’s a lot to digest.”

At first, he expressed skepticism.

“You’ve got to be a good salesman to sell this. Who would buy it?”

But he added that deals get priced in certain ways for a reason, which depends on a variety of factors – most often on clients’ demand.

Yield enhancement

“They’re probably trying to compete with a typical spread to Libor. Perhaps they have a client that needs that type of paper. They’re trying to satisfy an account. You have spreads to Libor out there, but it’s capped most of the time. I’ve seen 1.5% spread over Libor with a 7% cap.”

The three-month Libor is at 2.69%. If the notes price with the 400 bps spread, investors can expect a 6.69% interest rate.

“Obviously the worst-of gives you a nice coupon.”

But was the reward worth the risk? He did not think so.

Clever structure

“You don’t know what your coupon is. You’re getting equity exposure. If it was just the S&P and the Russell for instance, that would be OK. But they’re throwing emerging markets in there. There isn’t much correlation between emerging markets and the U.S.”

This market participant said he would be curious to know who had indicated interest in buying the notes.

The commission for the trade is 3.5%, according to the prospectus.

“It seems like a retail account,” he said. Institutional clients would not pay such fees nor would fee-based clients, he noted.

“Look, it’s a clever structure. There is always a buyer for something. I just think 10 years is a lot.

“But if someone is comfortable in the underlying, for someone who is familiar with emerging markets, which is where you get the vol., this may work.”

Issuer’s call

The discretionary call was not necessarily a negative. While investors assume that an issuer will exercise its right to call as soon as it can benefit from it, it is not always the case, he noted.

“When it’s autocalled, it’s automatic. You may not want to be called but you will get called. When it’s at the issuer’s discretion, there are many factors behind their decision. They may or may not call it. You may be able to run it a little longer,” he said.

Small return

A fixed-income trader was more critical about the structure in general.

“You’re not getting a lot,” he said.

“It’s callable, it’s a worst-of, there are three underliers, it’s a floating rate, you may not get paid. There are too many contingencies. At some point you have to draw the line somewhere.”

The structure type was counter to what his firm is pricing for its clients.

“What we see right now is very different. People want fixed rates. They also don’t want the contingency of the coupon right now. The only contingency they’re willing to accept is for the principal at maturity. They go for a European barrier at maturity, fixed and guaranteed coupon. That’s what people want right now.”

A European barrier is one that is observed point-to-point.

Even if the 50% barrier appears to be low it will determine the amount of return and the potential losses at maturity.

“To give contingency on the coupon and at maturity, you have to have an awful large coupon,” he said.

“6.5% doesn’t do it. It doesn’t fit that bill. You need a double-digit coupon for something like that.”

View on rates

The double-digit return will depend on the future direction of short-term interest rates. If those surge, the uncapped coupon could be high.

But this source does not expect rates to rise for some time.

“The [Federal Reserve] is not going to hike rates. We have no inflation. If anything, they’re going to cut rates again. You’re taking on a lot of risk for the next 10 years. And that’s a long time,” he said.

The notes are guaranteed by Citigroup Inc.

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

The notes will price on Feb. 26.

The Cusip number is 17326W886.

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