Citigroup's notes tied to MidCap ETF, S&P offer appeal despite geared buffer, unlevered gains

By Emma Trincal

New York, Feb. 3 - Citigroup Inc.'s 0% geared buffer securities due Feb. 17, 2017 linked to a basket that includes the S&P 500 index with an 80% weight and the SPDR S&P MidCap 400 ETF trust with a 20% weight have enough appeal to offset some of the negative terms such as geared downside and the lack of any leverage on the upside, sources said.

If the final basket level is greater than the initial basket level, the payout at maturity will be par plus the basket return, subject to a maximum return that is expected to be 30% to 35% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the basket level declines by 15% or less, the payout will be par.

If the basket level declines by more than 15%, the payout will be (a) $1,000 multiplied by (b) 1.1765 multiplied by (c) the quotient of the final basket level divided by the initial basket level.

"We're seeing a lot more of those geared buffers. A year ago, I almost never saw any," said Michael Kalscheur, financial adviser at Castle Wealth Advisors.

Defensive trend

The combination of unleveraged upside and leverage factors on the downside beyond a buffer is probably one of the techniques issuers are now using to generate better buffers over a shorter period of time, he said.

"Last year, it was all about leverage and longer durations, sometimes with high caps or no caps, but you had extended maturities and very weak buffers," he said.

"Now we're seeing shorter timeframes, unlevered upside and more attractive buffers, even though the buffer may have a gearing like this one. It's still a buffer, and it's still better than having a barrier."

The focus on more defensive structures is a result of the recent sell-off seen in the market. The S&P 500 this year is down 5.75% as of Monday's close. Last year, the benchmark was up 32.4%.

"Last year, investors wanted to jump in the market and participate in the rally, which is why the focus was on the upside or the leverage. After a 30% increase last year and the market down so far this year, we're seeing clients operating a little bit more on the cautious side, demanding shorter durations and more protective cushions on the downside," he said.

"I assume that firms are marketing more defensive products like this one in an attempt to respond to that new kind of demand. The current sell-off reinforces the need for more downside protection.

"A switch from leveraged notes with a minimal level of downside protection to notes that offer no leverage on the upside but more attractive buffers may already be a trend. I'm not sure if it is. But if it's not a trend yet, I can see it becoming one this year."

Geared buffer

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he usually avoids buffers with downside leverage, but this product is an exception.

"I like the notes. The downside leverage bugs me only when the underlying index is volatile, for instance when the notes are tied to the Russell 2000 or the EAFE. That's not the case here," Kunhardt said.

"You're talking pretty much exclusively of U.S. large caps with 80% in the S&P. You have some mid-cap, but it's a 20% weighting. I can live with 80%-20% S&P/mid-caps. I would have liked to see a bigger buffer, but three years is short enough that I don't feel locked in. But mainly, I'm relatively comfortable because I don't see this basket hitting the 15% threshold."

For Kalscheur also, the size of the buffer is enough to offset the risks associated with the downside leverage.

"The geared buffer is tricky, but I wouldn't consider it a deal-breaker," he said.

"A 15% decline in the market over a three-year period is pretty rare. And even if the basket was down 20%, you would still be better off."

A 20% decline in the underlying would cause investors to lose 5.88%, a small difference from the 5% loss an investor in a note carrying a standard 15% buffer would have to incur, he explained.

"It's only if you had a serious correction that you would be taking significantly more risk," he said, pointing to a 40% drop in the market, which would cause investors in the notes to lose 29.4% versus 25% with the normal buffer.

"But I think this drastic scenario is unlikely to happen anyway," he said.

Tenor, credit

Other positive aspects of the product include the relatively short duration, a factor that reduces credit risk, he said.

"Citi's credit is not bad. In terms of CDS spreads, it's just below JPMorgan and above Bank of America. All issuers have seen their spreads coming down over the past 12 months, a sign that the market recognizes that banks are in better shape," he said.

"Citi still kind of worries me though given that they almost went out of business a few years ago. But I guess it was true of other banks such as Goldman. They've shored up their balance sheet, and they're now in better shape.

"More important is the short duration. A short deal like this one reduces your exposure to credit risk. If it was a seven-year [note], it would be a different story."

Upside potential

Kalscheur and Kunhardt said they like the underlying basket as well as the possible upside.

"While not levered, the mid-cap element adds some juice and gives investors more upside potential," Kunhardt said.

"I could actually live with a 70%-30% allocation rather than 80%-20%. Mid-cap stocks are more volatile, and with that, you get the potential for higher returns. The structure offers a reasonable cap on the upside, and you want to hit the cap."

Even with an increased allocation to the S&P MidCap 400 ETF, Kunhardt said that the risk of breaching the 15% threshold remains limited.

"Although it's more volatile than the S&P, I would still feel comfortable because of the size of the buffer and also because I would invest in this note for the return, not as a hedge. The more volatile underlying basket would make it more likely to hit the cap while the odds of hitting the buffer in my view remains small."

Standard portfolio

For Kalscheur, the underlying basket offers additional advantages.

"This underlying is simple and easy to explain. You have a true basket. It's not a worst of. It's an 80%-20% mix," he said.

"A lot of large-cap active managers dip down into mid-cap. A lot of clients could very well be having 20% of their existing portfolios in mid-cap names. A 20% in mid-cap, 80% in large-cap reflects a typical allocation for a large-cap manager. No surprise here. It's pretty standard."

Kalscheur added that he is also comfortable with the 1.3% fee.

"It seems reasonable to me. Divide it by three: it's 43 basis points a year. It's very competitive," he said.

Unpaid dividends

Perhaps the biggest drawback of not having leverage on the upside is the fact that investors are guaranteed to underperform the basket if the final basket return is positive.

"The unlevered upside is problematic in one way," Kalscheur said.

"The 10% a year is not a bad return. If you can lock in 30% a year, most clients would be happy. But you're losing that dividend, and the absence of any leverage prevents you from making up for it. That's the problem."

The annual dividend yield for the S&P 500 and the MidCap 400 ETF is 1.8% and 1.2%, respectively. With the weightings, the unpaid dividend is about 1.7% a year.

"I can live with that. But you will underperform the underlying basket by 5% over the course of the three years," he said.

Overall, Kalscheur concluded that the structure is average. Many of the more attractive features offset some of the negative terms, he said.

"There is nothing fancy or exciting about this product. There's no leverage. But there is nothing that says I couldn't invest in it," he said.

"In fact, there are enough of right things in it, like the buffer, the cap, the term, that could make this product a nice addition to somebody's portfolio.

"I would certainly look at it. It doesn't mean that I would buy it. But it's a nice offering. It's a plain-vanilla note. Sometimes plain vanilla is the best thing for you."

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price Feb. 14.

The Cusip number is 1730T0H44.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.