Citi’s $1.41 million contingent coupon autocalls on Qualcomm, Microsoft show lower call strike

By Emma Trincal

New York, July 10 – Citigroup Global Markets Holdings Inc.’s $1.41 million of autocallable contingent coupon equity-linked securities due Jan. 4, 2023 linked to the common stocks of Microsoft Corp. and Qualcomm, Inc. are more likely to be redeemed early than similar products due to a barrier level, which facilitates the exercise of the call, said Tim Mortimer, managing director at Future Value Consultants.

Each quarter, the notes will pay a contingent coupon at the rate of 9% per year if the laggard stock closes at or above its coupon barrier value, 70% of its initial share price, on the valuation date for that period.

The notes will be automatically called at par plus the coupon if each stock closes at or above 90% of its initial share price on any quarterly valuation date.

If the final share price is greater than or equal to the 70% barrier level, the payout will be par. Otherwise, investors will be fully exposed to the decline of the laggard stock.

Correlations

As with any autocallable worst-of, both correlations and volatilities will determine the size of the coupon and the barrier levels, said Mortimer.

But the note offers something different.

“Here the call strike is below the initial price at 90. It’s quite unusual and it adds a new dimension to the pricing. It’s also going to impact the call,” he said.

The correlation between the two stocks is 87%.

“It’s pretty high, and that makes sense. They’re in the same sector, same country although the industries are different,” he said.

Both stocks belong to the technology sector. But Qualcomm, a provider of digital telecommunications products, operates in the semiconductor industry. Microsoft is a leading software company.

Volatility

Qualcomm has a 34.3% volatility.

“It’s fairly high although not crazy high compared to the S&P, which is around 22%,” he said.

Other semiconductor stocks, such as Marvell Technology Group Ltd. or Nvidia Corp., have higher volatility levels than Qualcomm.

Microsoft showed a lower volatility than Qualcomm at 28.5%.

Lower call strike

The lower threshold for the automatic call does not help boost the yield.

“Because it’s easier to get called at 90 than it is at 100, your coupon is going to be lower,” he said.

Mortimer generated a report for this note, to illustrate his point.

Future Value Consultants offers stress-testing and back-testing analysis on structured notes.

Each report contains 29 sections or tests, which display the probabilities of outcomes pertaining to a particular product type. In the case of a Phoenix autocallable product such as this one, probability of full capital return, total return loss and call at various dates can be found in one of the most commonly used tests called investor scorecard.

Short duration

The notes will be called at point one – or after three months – two-thirds of the time, according to the scorecard.

“It’s unusual to see such a high probability for a first call in any autocall. On average the probability for a call at point one is 50% or even 45%. But it’s not that high,” he said.

At the same time, almost all call triggers are at par.

“Obviously the 90% threshold makes it more likely to get called especially after only three months,” he said.

The exercise of the call reduces the chances of losing money at maturity, he added.

With less risk, the premium paid to investors is lower.

“So even though we have a worst-of on two stocks, you’re likely to come out of this note very quickly. There is no no-call feature. You have to be ready to come out in three months with a 2.25% return,” he said.

For a call on the second quarterly date, the probability was 8%.

“You can expect this note will last six months rather than two-and-a-half years. The simulation shows that 75% of the time, the product is going to be redeemed within the first six months,” he said.

However, past the first six months, investors are much more likely to hold the notes until maturity, which is a normal distribution of probabilities common to all autocalls, he added.

“After you miss point two, your probabilities of calling rapidly disappear,” he said.

Loss scenario

The scorecard also revealed an 11% probability for investors to lose principal, which only happens when the barrier is breached at maturity. The consequences in this case are dire: the average loss amounts to 57% of principal, the report showed.

“This is a very skewed bet. You have an 85% chance of being called. But if you lose, the impact is quite drastic,” he said.

No call, no pain

When the notes are not called, which is 15% of the time, there is only a 4% chance of avoiding the barrier breach.

In such unlikely and happy ending, the underlying price finished below the 90% call strike but above the 60% barrier. Such scenario requires failing the previous 10 call tests, which explains while the probability associated with such outcome is so small.

In addition to its Monte-Carlo simulation, Future Value Consultants also provides back-testing analysis.

The back-testing showed that the notes never lost money both on a five-year and 10-year timeframe.

“This reflects the strong bull market we had in the last five and also 10 years, especially with tech stocks,” he said.

Product specific

The report contains another table called product specific tests, which displays probabilities for the same outcomes but through four distinct market scenarios: bull, bear, less volatile and more volatile.

The scorecard was premised upon the neutral scenario, which reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

Market assumptions

“Our market scenarios differ in terms of the market direction and changes. But we keep the same volatility levels,” he said.

This helps explain why the differences in probabilities for a first call are not significant across the four market assumptions showed in the product specific tests.

In the bull scenario and the volatile scenario, the call at point one occurs 69% of the time.

It drops to 62% in the bear scenario and the more volatile scenario.

Two factors are at play.

“First, in three months, the volatility does not have much time to take effect,” he said.

Volatility, direction

Another factor increasing similarities is the fact that bull market and low volatility distributions behave similarly the same way as bear market and high volatility scenarios do, but in opposite directions.

“If volatility is high there’s a greater chance that one of the stocks will drop, which will affect your calling. That’s why high volatility and bear market tend to act the same way. They both show probabilities of 62%,” he said.

But whether the odds are 69% in the bull and low volatility scenarios or 62% in the two others market environments, the differences are not significant, he said.

“They’re all in the 60’s. The call is not hugely sensitive to market assumptions,” he said.

Tough bet

Investors considering the notes should be confident that neither of the two stocks will drop more than 40% in two-and-a-half years, he said.

“You must have that conviction. Because if you’re wrong, the impact is really bad.

“You know you have a high chance of getting your 9% per year early on.

“But there’s still a chance of big losses, at least 40% by definition.”

All autocallables with contingent coupon are based on the same paradigm, he said.

There are “high chances of getting something and low chances of losing a lot,” he said.

“This note pushes that argument even further by combining the 90% strike and the first call in three months with no call protection.

“Chances are you’ll get your 2.25% in three months.

“But be prepared to lose at least 40% if things don’t go according to plan.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on July 2.

The Cusip number is 17328VYP9.

The fee is 3.25%.

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