Advisers comfortable with barrier level on Citi’s dual directional notes on EAFE ETF, Stoxx 50

By Emma Trincal

New York, May 28 – Citigroup Global Markets Holdings Inc.’s 0% dual directional barrier securities due June 10, 2025 linked to the worst performing of the Euro Stoxx 50 index and the iShares MSCI EAFE exchange-traded fund give advisers a certain level of comfort when it comes to the 70% downside barrier over a five-year term even though the exposure is to the worst of the two underlying assets.

If each index finishes at or above the initial level, the payout at maturity will be par plus 1.8 times the return of the lesser performing index, according to a 424B2 filing with the Securities and Exchange Commission.

If the laggard index falls but finishes at or above the 70% barrier level, the payout at maturity will be par plus the absolute value of the return of that laggard index.

Otherwise, the payout will be par plus the laggard index return, with full exposure to losses.

Healthy level

“It’s a nice simple concept. There are a few moving parts...actually, a lot of moving parts. But the leverage and the no-cap make it pretty interesting,” said Steve Doucette, financial adviser at Proctor Financial.

“I’d be comfortable with that 70% barrier level. I mean, five years out, are we going to be worried about the barrier? It’s hard to call. But it’s a pretty healthy level.”

Doucette thrives to get deeper barriers when he can. But on a five-year maturity, 30% in contingent protection based on the two international equity indexes seemed to be sufficient in his view.

“Most notes we’re trying to do have a 40% barrier. But from 40% to 30% I wouldn’t be too concerned. In both cases you’d have a bad situation five years from now. I’m not sure it would make such a difference.”

The five-year maturity was acceptable too although Doucette said he has done better in the past on the same two indexes.

“We try to keep it shorter. We’ve done that before. But sometimes you need to go out a little bit longer to get better terms,” he said.

Comparison

He mentioned a deal he bought a little more than three years ago with similar terms – worst-of payout, nearly identical underliers, leveraged upside and absolute return. This deal matures in four months.

“It was a three-and-a half year note with a 40% barrier. Shorter maturity ... and the leverage was higher. But there’s a cap even though at 12.5% a year it’s a pretty good cap.

“We also had the absolute return down to the barrier,” he said.

He was referring to an innovative note issued in March 2017 by JPMorgan Chase Financial Co. LLC for $21.9 million. The 0% capped dual directional leveraged notes due Sept. 24, 2020 referenced the same two underlying except that the MSCI EAFE was the index, not the ETF. The 2.85x upside leveraged factor applied to an equally weighted basket consisting of the two indexes up to a 50% cap.

By default, the payout was not a worst-of. But it became one if at maturity the basket price breached a 60% barrier, in which case investors were exposed to the worst-performer with downside exposures. If the basket finished negative but above the barrier, investors would get 50% of the absolute return. This capped the potential gains on the downside at 20%.

The “deleveraged” absolute return on the way down allowed the issuer to generate more leverage over a shorter period. In addition, the barrier was deeper, and investors had a chance to avoid the worst-of payout. In exchange, the upside had to be capped and the absolute return cut in half.

Doucette said that his note has outperformed on the upside but not as much as he had expected. But the advantage of the absolute return was to have an opportunity to generate an even better return if the market was to drop again.

“There’s definitely potential to outperform on the downside,” he said.

High correlation

One advantage of using the two underliers in the Citigroup (and JPMorgan) notes is the reduced dispersion risk due to European stocks comprising 65% in the iShares EAFE fund. Such high weighting overlaps with the Euro Stoxx 50 index used as the euro zone benchmark.

The five-year coefficient of correlation between the two underliers is 0.967, according to FactSet. The near-perfect correlation limits the risk associated with any worst-of.

Financials red flag

This doesn’t mean there is no risk in getting exposure to European stock markets, said Doucette.

“The EAFE and the Euro Stoxx are correlated by country. But those indexes are overweight financials. That could be an issue depending on where interest rates are heading to,” he said.

Financials are the top sectors in both the Euro Stoxx 50 index and the iShares MSCI EAFE fund. In each of the portfolios, they have a sector weighting of approximately 15%.

“When rates are low as they are now, banks get lower margins on their loans. It’s not good for the sector.

“Economists have been predicting inflation and higher rates for a while and it’s still not happening. So, who knows?”

Doucette is not necessarily bullish on the fundamentals of European large-cap stocks. But he believes there is potential for appreciation over the time frame.

“Europe has been an underperforming asset class for a long, long time. But that’s precisely why they may come back. If you believe in reversion to the mean, it should happen.”

Fine tenor

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said he liked the underlying assets and the timeframe.

“I like both indexes over the next five years,” he said.

“I haven’t done the math, but I don’t believe there is a five-year period where they would have breached the barrier.

“So, I don’t mind being exposed to the worst-performing one.”

The leverage factor was attractive as well as the uncapped upside exposure, he noted.

“I also like the absolute return component to the offering.”

Medeiros is more optimistic over a long time horizon.

“It’s hard to make a call short term. But over the next five years, I’m certainly bullish on the underliers,” he said.

“Europe is incentivized to create a competitive environment, and I expect growth looking forward.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on June 3.

The Cusip number is 17328VNA4.

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