Citi’s contingent coupon autocalls on Junior Gold Miners to offer high-yield, potential hedge

By Emma Trincal

New York, Jan. 23 – Citigroup Global Markets Holdings Inc.’s planned autocallable contingent coupon equity-linked securities due Feb. 1, 2019 linked to the VanEck Vectors Junior Gold Miners exchange-traded fund offer above-average income for investors who are not overtly bearish on the underlying fund, sources said.

Alternatively, the notes can be used as a hedge for a long position on this asset class, an adviser said.

The notes will pay a contingent quarterly coupon at an annualized rate of 9% to 10% if the underlying fund closes at or above its 80% coupon barrier on the valuation date for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The exact coupon will be set at pricing.

The notes will be called at par plus the contingent coupon if the fund closes at or above its initial share price on any quarterly valuation date.

The payout at maturity will be par plus the contingent coupon unless the fund finishes below its 80% barrier level, in which case investors will be exposed to any losses.

Short volatility

The notes’ main purpose is to provide income, said Elliot Noma, founder of Garrett Asset Management.

“You’re short volatility, and that’s how you get this high coupon,” he said.

But investors need to have a range bound view on the underlying.

“You can’t be too bearish; otherwise you hit the barrier. You don’t want to be too bullish either. You would lose on the upside, and if it’s called too soon, that ends the income flow. It has to trade in this corridor between 100 cents and 80 cents.”

For investors holding this view and looking for income, the notes could be an option. But it would be a risky one.

“You have to be an income hawk. You do get a high coupon and it’s hard to find.

“But it’s risky because the stocks in this ETF could be jumping all over the place,” he said.

Long the ETF, short the vol.

Another approach could be to use the premium as a hedge.

“It would be great to own this note for investors who already have a position in the ETF or in gold and they’re looking for some insurance. If it’s down a little bit then that’s fine. And if it’s up, if you’re called at par, so what?”

Investors would profit from the uptrend since they have a long exposure to the fund and they would collect their final coupon.

Alternatively, the notes could be used as a tactical play against the dollar, he noted.

“Being long gold is sometimes considered being short the dollar. This is more of a stretch, but it’s conceivable to use the notes as a bearish play on the dollar if that’s your view,” he said.

Less junior

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said the underlying fund was volatile by nature despite rebalancing changes in the ETF, which were implemented last year. This adviser was not comfortable with the risk-adjusted return since the upside is capped.

“It has the potential to skyrocket. That’s why people buy it,” he said.

In June, the rules of construction of the ETF changed, increasing the market capitalization of the fund.

“The amount of money flowing into the junior was overwhelming. They had to raise the market cap level,” he said.

As a result, the weighted average market capitalization of the fund jumped to $1.7 billion from $967 million, according to Van Eck’s website. But the “junior miners” remain composed of smaller-cap stocks in comparison to another VanEck Vectors’ highly traded ETF: the Gold Miners, listed on the NYSE Arca under the ticker symbol “GDX,” shows a weighted average capitalization of $8.9 billion.

Not surprisingly, the implied volatility of the “junior” fund, listed under the ticker symbol “GDXJ,” exceeds that of the regular GDX miner fund with an implied volatility of 26.4% versus 21%, respectively.

Timing the capping

“It’s a volatile fund. I’m not sure I’m a big fan of these kinds of structures because the only way you could benefit is if it goes down just a little bit and not up. Weird bet for something that can move a lot,” he said.

In “monetizing” the volatility for income, investors are giving up the benefit of the equity exposure, he added.

“The whole reason to buy GDXJ is for the upside,” he said.

“Returns on gold stocks can be astronomical, especially with this fund, which hasn’t done great for a while.”

The VanEck Vectors Junior Gold Miners ETF was down 5.35% over the past 12 months. Its less volatile cousin has gained 4.25% during the period.

“You’re capping yourself at a time when this asset class could strongly rebound. And you’re still exposed to the downside,” he said.

Go long

Despite the barrier providing 20% in contingent protection, investors can still lose their entire investment, he noted.

“You’re giving up a huge upside potential. And you’re getting the full downside exposure unless coincidentally at the end of the year the fund happens to be down less than 20%.”

Chisholm said that he understood the rationale of the note as investors badly need yield in the current environment.

“But this is not the way to get income. You don’t get income on a speculative investment. It’s not the way it works. You’d be better off buying the ETF outright with full liquidity. You’d get the risk and the full reward.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes will price on Jan. 29.

The Cusip is 17324XJN1.

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