Citigroup’s contingent buffered digital notes linked to SPDR S&P Bank ETF aimed at contrarians

By Emma Trincal

New York, March 23 – Citigroup Inc. plans to price 0% contingent buffered digital notes due April 12, 2017 linked to the SPDR S&P Bank exchange-traded fund, according to a 424B2 filing with the Securities and Exchange Commission.

If the final share price is greater than or equal to 85% of the initial share price, the payout at maturity will be par plus 10.7%. Otherwise, investors will lose 1% for every 1% that the ETF finishes below its initial share price.

“This deal is for investors who believe that bank stocks are likely to go up and unlikely to go below 15%. It’s really based on the view that bank shares offer value,” a market participant said.

“I can see the reasoning behind the bet. It doesn’t mean I share the view.”

Value investing has attracted more investors this year, he said.

Bargain stocks offering value have underperformed during the bull market, and value investing has been out of favor. Now more research firms recommend oversold, good-quality stocks in the hope that they will recover, he explained.

“Bank stocks have been beaten up. The headlines show a gloomy picture. Recession fears and the oil sell-off have hit stock prices in the banking sector since the end of last year. It has improved recently, but who knows for how long? If you look at investment banks, they’re still cutting jobs, they’re reducing their assets. Meanwhile rates are still low, which means profit margins remain under pressure.”

Underperformer

The SPDR S&P Bank ETF tracks the performance of the S&P Banks Select Industry index, an equal-weighted index that represents the banks industry group within the S&P Total Market index.

The fund has strongly underperformed the market: it has declined by 9.6% while the S&P 500 index is now flat. Over the past year, the ETF declined by more than 10%, compared with a 3.4% loss for the S&P 500.

“The good part of the deal is that you’re not betting on one bank. This is a diversified portfolio of banks. It’s also a way to narrow your focus on banks only at the exclusion of other financial companies,” he said.

The fund has 62 holdings as of Monday, according to State Street Global Advisors, the fund’s manager.

Contrarian view

“If you buy this note, you are a contrarian. You believe that banks are oversold, that there is no way they can breach the barrier a year from now. If that’s your view, it’s a good way to make almost 11% in one year. I don’t see it that way, but at least this is a rational view. It makes sense. That’s what the structure is,” he said.

Structured notes are a way to express a specific view that may not be easily replicated with stocks, he said.

The structure allows investors to get a fixed return at maturity as long as the underlying price does not decline by more than 15%.

“How else would you get that type of payout in one instrument? This is a fixed return and a downside protection. You can’t just do it by just buying the stock or shorting the stock. This is how structured notes are helpful. They can deliver a specific payout that reflects your view,” he said.

Value

The view cannot be overly bullish since the digital return caps the upside, noted an industry source.

“This is definitely a value play. You believe the market is oversold, banks are oversold. At the same time, you’re limiting your upside to 10%. You’re kind of bullish toward the banks but not truly bullish,” he said.

Some value investors may not want to limit their upside if they believe that the upside potential is strong in a recovery scenario, he added.

Betting on banks may be premature, according to this source.

“That to me, given the state of the banks, is a pretty risky bet,” he said.

“I don’t know if banks are fairly valued or if it’s expectations, but prices are still pretty low. Spreads were widening not that long ago. Fixed-income desks took losses. The 10-year rate started to recover. It was below 1.7% last month. Now it’s at 1.9%, but it’s not great.”

Timing

With fears of a global recession receding and oil prices now rising, the market has been trading on the upside. This is encouraging, but the resiliency of the rally matters.

“The market is usually good at anticipating recessions,” he said, referring to the shape of the Treasury yield curve.

The curve flattened earlier this year as plunging oil prices were seen as signs of a global economic slowdown. Recently the oil rally and positive U.S. economic data, notably on the job front, have eased those concerns, widening the yield spread between shorter and longer maturities on the curve.

“It looks like the market is not anticipating the U.S. to go into a recession anymore,” he said, adding that it is probably the rationale behind the deal.

“It would be interesting to see if this bet turns out to be rewarding.”

Citigroup Global Markets Inc. is the underwriter.

The notes were expected to price Thursday.

The Cusip number is 17298CD96.

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