Citi’s three-year buffered digital notes tied to S&P, Russell show attractive worst-of structure

By Emma Trincal

New York, Nov. 26 – Citigroup Global Markets Holdings Inc.’s 0% buffered digital notes due Dec. 3, 2021 linked to the lesser performing of the S&P 500 index and the Russell 2000 index give investors a chance to outperform the market with more protection than a long-only position, advisers said, making the product attractive. An adviser said however that he would prefer to see the term reduced to two years.

If each index finishes at or above its 75% threshold, the payout at maturity will be par plus the greater of the digital return of 17.5% to 19.5% and the gain of the worse performing index, according to a 424B2 filing with the Securities and Exchange Commission.

Otherwise, investors will lose 1% for each 1% decline of the worse performing index beyond 25%.

“I like the exposure because U.S. equity is a core asset class. You’re always going to have it in your portfolio no matter what,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“The question as always is: am I better off holding the position long or holding the notes?”

The answer for him was positive due to the 25% hard buffer and the enhanced return, which can be obtained anywhere between the buffer threshold and the digital coupon level.

“I would have this in my portfolio anyway. I’ve got a nice comfortable buffer and no cap,” he added.

View-dependent

A potential investor would also have to have a sense of “where we are in the market cycle” in order to assess which among the two indexes is the most likely to be the worst-performing one, determining the outcome of the investment.

“If your view is that we’re at the top and that we’re beginning a new period of market decline, then the small-cap index is going to lead you down. Your notes will be tied to the Russell,” he said.

Even under this market scenario, the notes remained defensive in nature due to the 25% buffer, he noted.

“Then you have to ask yourself the question: could we see the market breach the 25% level in three years? It’s unlikely. We never had a three-year downturn. Think back 1929-33. The crisis was driven by poor economic policies. We never had a three-year bear market. They usually last 12 months, 18 months at the most.”

Timing

The real risk would be if a bear market occurred at the end of the three-year timeframe, toward the last year.

“I guess that’s clearly the challenge. You could be well below that 25% in that case because the Russell is the most volatile.

“That’s something you have to keep in mind. But it doesn’t change the fundamental premise: if we’re at the end of a 10-year bull market, your note is going to be linked to the Russell.”

A tale of two bulls

Kunhardt said he did not expect the market to drop significantly during the period, in fact quite the opposite.

“We’ve had a fairly continuous bull market and it’s likely to continue. The economy took a long time to recover and it has never had an opportunity to overheat. Most markets perform according to the underlying economy and the economy is strong,” he said.

Under this scenario, investors are most likely to see their investment tied to the S&P 500 index.

“If we continue to grow, small caps will outperform large caps. My worst-of is going to be on the S&P. But it doesn’t matter because under this scenario, large caps are still going to do significantly well and I still have an uncapped note.

“It’s just a lost opportunity. I’m getting exposure to the worst-of. That’s all.

“But I always have to have exposure to the S&P anyway. Instead of buying the index, I’m getting the exposure with an uncapped upside, a buffer and a digital gain if I’m down 25%.

“It’s a beautiful note.”

Too long

Steven Foldes, vice-chairman at Evensky & Katz / Foldes Financial Wealth Management, said he liked the notes “conceptually” but would not want to invest in it for three years.

“We would need to shorten the term. Three years is too long for us,” he said, adding that he keeps the duration of his structured notes typically below two years.

“Conceptually, though, I like the note. I like having an uncapped return.

“The worst-of doesn’t bother me because the correlation between those two major U.S. indices is so high.”

The S&P 500 index and the Russell 2000 index have a 0.85 coefficient of correlation.

“We also like a lot having a digital coupon if the index is negative, down to 25%.”

Going back to his objection to the length of the product, Foldes said that although having a 25% buffer was “nice,” it was also probably unnecessary because the chances of using it over a three-year period were slim.

“It’s overkill for a three-year. The note would become more compelling if it was a two-year tenor because the chances of losses over two years are greater,” he said.

Customized remake

In order to be satisfied with the product, Foldes said he would need to shorten the tenor by one third.

“On a two-year, we would be willing to reduce the buffer to 20% or even 15%, which would probably be sufficient. That way we would get a digital coupon in the neighborhood of what they’re offering now at around 17% to 19%.”

Commentators are predicting greater chances of a recession in 2019 or 2020, which may increase the risk associated with a note maturing in two years, he added. But buffers remain a good response to risk.

“The idea of having a hard buffer against that along with an unlimited upside is a very intelligent way of dealing with the uncertainty,” he said.

“If your view is that we’re looking at a rocky road ahead, a two-year note with a buffer on the downside, a digital coupon even if the market is down and uncapped upside makes a lot of sense. It’s a very solid note.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes will price on Nov. 30.

The Cusip number is 17326YUW4.

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