Citi’s $1.2 million dual directional notes on S&P ETF unlikely to outperform, advisers say

By Emma Trincal

New York, Jan. 30 – Citigroup Global Markets Holdings Inc.’s $1.2 million of 0% dual directional barrier securities due July 29, 2025 linked to the SPDR S&P 500 ETF trust are designed to beat the market on the downside, advisers said. But the chances of success for investors are limited, they said.

If the ETF gains, the payout will be par plus the ETF return subject to a maximum return of par plus 30%, according to a 424B2 filing with the Securities and Exchange Commission.

The payout will be par plus the absolute value of the ETF return if the ETF declines but ends above the 72% final barrier.

Investors will lose 1% for every 1% that the ETF declines if it finishes below the final barrier, payable in shares or cash at the issuer’s option.

The securities are non-callable.

Core holding

Carl Kunhardt, wealth adviser at Quest Capital Management, said his market outlook did not match the best scenario associated with the structure, which is mainly bearish.

“It’s a hard call,” he said.

“The main question for me is always: am I better off holding the position long or via the note?”

From an “asset allocation standpoint,” Kunhardt said the answer to this question was neutral because he has to hold the S&P 500 index in his core holding portfolio anyway.

“It’s large-cap. Holding the position outright or with the note doesn’t matter. It’s a wash,” he said.

Dangerous cap

The cap in his view was the key issue.

“On the upside, I have a ceiling of about 10.5% a year. On the plus side, 10.5% exceeds the return expectations we go with,” he said.

He was referring to Mercer’s projected annualized returns for the S&P over the next five years, which is 8%.

“At least the cap is not below the forecast. It’s a little bit above that. “You get an extra 2.5%,” he said.

But this adviser’s market view was more bullish than that.

“This is a two-and-a-half year. It’s not six months. Everyone agrees that we’re either at or near a bottom cycle. At maturity, the recovery will have happened. Do I want to limit myself to 10.5%? Coming out of a downturn is when you pick up all of your return,” he said.

Good but useless

The structure on the downside was more suitable for a bearish view, he noted.

“The 28% barrier is a nice barrier,” he said.

“Compared with the ETF, if I breach the barrier, I’m no worse off than being long the ETF. But if I don’t breach, not only do I get the protection, I also get the absolute return kicker.

“So, the barrier is a plus. But if I look at a two-and-a-half-year timeframe, am I going to need it? Is the barrier worth having a 10.5% cap when there is a low probability that I’m going to use it?

“It’s hard to get excited over the downside with such a low cap.”

Modifying the upside

Rather than increasing the leverage, Kunhardt, who is bullish over the period, would seek to increase the maximum return.

“I would probably get rid of the absolute return in order to get a higher cap,” he said.

“The barrier alone is a great feature. It’s a benefit. But it cost you too much in terms of upside potential.”

Even as a hedge, Kunhardt would not consider using the note.

“My view is not bearish for that timeframe. Even if we go through a downturn, the S&P is not going to be down in two-and-a-half years especially after the negative returns of last year,” he said.

Dual directional scenario

Another financial adviser found the notes overly bearish and unlikely to outperform.

Some features however were attractive.

“Two-and-a-half years is more of an intermediate term timeframe. The 28% barrier is deep, which is good,” he said.

The dual directional feature was also a plus.

“Both terms make it clear that the note is basically biased toward negative to below average,” he said.

But the upside payout was not as compelling as the downside structure.

Looking at back-testing data on the S&P 500 index for two-and-a-half year rolling periods, this adviser found that the odds of outperforming the underlying ETF were limited.

For instance, the odds of the ETF dropping 28% or less were small.

“You only capture the absolute return 13.3% of the time. That’s where you get the biggest outperformance. But you’re not very likely to benefit from it,” he said.

The barrier played an effective defensive role, he noted. The chances of breaching the 72% threshold were only 3.5%.

“I get nervous when the probability of breaching a barrier is 5% or more. Under 5%, I’m comfortable. The barrier is definitely not the problem,” he said.

Disappointing upside

On the upside, investors will get the full participation in the ETF below the 30% cap 47% of the time, he noted.

“Almost half of the time I’m giving up my dividend income just to keep pace with the market. Not a good situation,” he said.

Finally, the risk of seeing the underlying rise above the cap happened 36.2% of the time.

“Almost a third of the time, I’m leaving money off the table. This is the only scenario where I’m underperforming the market, and if it can happen quite easily – a third of the time – that’s a lot.”

Overall, the distribution of probabilities was not favorable to noteholders.

“There’s an 83% chance that you’ll either replicate the index minus the dividends or be capped out,” he said.

Investors would be better off being long the ETF or adding leverage to the note even if it meant eliminating the dual directional feature, he said.

“If the note had 1.5x leverage it would be more reasonable. You would have a chance to beat the market.”

“When you look at any of the parts, it’s not necessarily bad. But when you add them together, it’s not a compelling story.

“There’s just not enough incentive to justify the investment.

“I’d probably pass,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The note settled on Friday.

The fee is 1.75%.

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