Citi’s $397,000 dual directional barrier notes tied to Dow may not require as much protection

By Emma Trincal

New York, Nov. 28 – Citigroup Global Markets Holdings Inc.’s $397,000 of 0% dual directional barrier securities due Nov. 28, 2022 linked to the Dow Jones industrial average offer leverage and uncapped upside with a dual directional feature and barrier protection on the downside.

But sources said the likelihood of breaching the barrier over the length of the notes is small, hence making the protective features of the structure less relevant, according to one financial adviser.

If the index finishes at or above the initial level, the payout at maturity will be par plus 128% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

If the index finishes below the initial level but at or above the barrier level, the payout at maturity will be par plus the absolute value of the index return. The barrier level is 70% of the initial index level.

If the index finishes below the barrier level, investors will be exposed to the index’s decline from its initial level.

Required allocation

“It’s a no-brainer. Between being long the index and this note, I would choose the note. You have to have exposure to the mega-cap sector anyway. For anybody, the Dow has to be a core allocation. The question is whether you get exposure through an index fund or through the notes. I would choose the notes,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

The underlying index is not without risks though.

“It’s only 30 stocks, and I usually like more diversified indexes. But again it’s got to be part of your portfolio. When the market forces you to rebalance, you may cut your international equity bucket or you may reduce the U.S. small-cap exposure, but you’re always going to keep your allocation to the Dow,” he said.

Peak

Current valuations are also somewhat of a concern. The Dow hit an all-time high last week.

“The entry point is not ideal,” conceded Kunhardt.

“The benchmark is trading at very rich levels right now, so it’s a concern. Every time you see the words ‘all-time high’ you have to be concerned.”

Low probability of losses

At the same time, Kunhardt said that the long tenor limits the odds of a decline in excess of 30%.

“There is not in my knowledge any six-year timeframe in which the Dow has been down point-to-point, let alone down 30%,” he said.

He added that perhaps periods that began with a crash (2000-06) or ended with one (2000-08) may have shown a decline, but not a 30% drop.

“The probability of losing money over a six-year period is pretty slim,” he said.

When compared with a long position, the notes offer the benefit of the barrier.

“With the notes: the Dow is down 25%, you don’t lose. Forget about the absolute for a moment. First you don’t lose. And then on top of that, you make 25%. It’s gravy.”

Credit risk, no dividends

Investors need to keep in mind that they don’t own the underlying index, however.

“The note is an unsecured debt. You have the credit risk. You also don’t have the dividends,” he noted.

But the loss of dividends is the case with most structured notes, he added. In this case, the leverage helps investors get even.

“Even though you don’t get the dividends, you will capture almost the total return with the leverage, and there is no cap. In addition, you get the protection and the absolute return.

“To me, it makes more sense to get the exposure through the note than through the index.”

Too long

Steven Foldes, vice-chairman of Evensky & Katz/Foldes Financial Wealth Management, said he does not like the long duration combined with the dual directional feature as it limits the potential upside. Because the benefits of the dual directional feature are unlikely to be used, it ends up costing investors too much.

His initial criticism is the term.

“Six years is just way too long for us,” he said.

For such a long time, there is little need for a barrier, he added.

“I don’t think a long-term note mandates a dual directional given that it’s unlikely that you’re going to be negative at maturity. I don’t even think it requires a barrier,” he said.

Downside pricing

“In fact, the downside protection is almost illusionary.”

The absolute return has a cost that ultimately investors end up bearing.

“First, you have a 30% barrier, which you have to pay for somewhere ... and it’s unnecessary because you’re unlikely to finish down. And second, you pay for a dual directional, something you have a very modest probability of being able to take advantage of. It doesn’t make sense to me.”

Rebuilding the structure

Foldes said he would rather shorten the duration of the notes and increase the leverage even if it means getting less downside protection.

“My priority would be to have a shorter note. If it was a very short-term note, a two-year for instance, having a dual directional would make sense. Obviously, the terms wouldn’t be nearly as good.

“I would want to see more leverage either uncapped or with a high cap.”

The 3.25% fee, which represents about 54 basis points per annum, is also a problem.

“They charge 3.25%, which seems like a lot to me. It’s not as if they charged you 54 bps per year. They take the fee upfront. You’d have to pay a severe penalty for getting out early.”

The notes (Cusip: 17324CCB0) priced on Nov. 18.

Citigroup Global Markets Inc. was the underwriter.

Citigroup Inc. is the guarantor.

The fee was 3.25%.

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