Citigroup’s 1% principal-protected notes linked to S&P 500 offer upside, guaranteed coupon

By Emma Trincal

New York, Sept. 26 – Citigroup Inc.’s 1% market-linked notes due Oct. 7, 2021 tied to the S&P 500 index are an unusual type of principal-protected note in that they combines upside participation with a fixed interest rate, albeit a modest one, said Tim Mortimer, managing director at Future Value Consultants.

Interest is payable semiannually.

The payout at maturity will be par plus the average index return, subject to a minimum payout of par and a maximum return of 24% to 26%. The exact cap will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The average return will be set using the arithmetic average of the interim index return percentages on Jan. 4, 2021, April 5, 2021, July 2, 2021 and Oct. 4, 2021.

CD-like coupon

“This structure is not very common,” Mortimer said.

“They pay a 1% per annum coupon, and they have a call spread to pay a maximum return of 24% to 26% depending on the final level.

“It’s an upside principal-protected structure paying income, which is pretty rare.”

The main idea behind the structure is to give investors the opportunity to beat the risk-free rate, he said.

“The 1% coupon is not very high; you can get CDs paying that level. ... but it’s still good,” he said.

“You get about half of the [risk-]free rate – [the seven-year Treasury yield is 2.2%] – and if the S&P goes up, you have the potential to earn an additional 25% from the upside participation. Add to this your 1% coupon, and that’s a 32% return over the seven-year term, which is 3% per year with the compounding. It’s not much, it’s not terribly exciting, but you know that you’re getting 1% guaranteed each year with the potential to get 3%.

“This is a product trying to outperform cash.”

The notes are designed for investors who want the equivalent guaranteed return of a CD rate but with the opportunity for more, he explained.

While a 3% return per year does not seem much, the notes remain an equity-linked product given the underlying asset class and the upside participation.

“You will get 7% guaranteed, and you can get up to 25% from the equity return. It’s the equity that contributes to most of the return. This is why the notes shouldn’t be viewed as an income product even though market risk is reduced to nothing,” he said.

Credit risk exposure

The market risk is eliminated by the principal protection, but the notes are not without risk, he warned.

“This is for conservative investors. But you still have exposure to risk. The risk you’re taking for seven years is to be exposed to Citi credit risk, which is something that needs to be taken into account,” he said.

“Citi’s credit spreads are not very high. Most CDS spreads are at low levels today compared to funding rates in the last 10 years.

“But seven years is a long time. You could have a market or economic event, and Citi could get downgraded anytime during this period.

“If you asked that question in 2007, which was exactly seven years ago, Lehman was still here. You might have felt things were fine at the time. So the notes are for someone who is comfortable with Citi risk for that seven-year term.”

Future Value Consultants measures the risk associated with a structured note with its riskmap. The rating measures the risk on a scale of zero to 10 with 10 being the highest level of risk. The riskmap is obtained by adding its two sub-components: market risk and credit risk.

The notes have a 1.13 credit riskmap, which is slightly more than the 1.07 average score for principal-protected notes and much higher than the 0.52 general average score, according to Future Value Consultants’ research report.

Citigroup’s five-year credit default swap spreads are at 70 basis points. Spreads for Goldman Sachs (83 bps) and Morgan Stanley (81 bps) are wider while JPMorgan (62 bps) and Wells Fargo (47 bps) have tighter levels, according to Markit.

The market riskmap of the notes is zero as a result of the full principal protection. The all-product-type category has an average market risk score of 2.98.

“We take Treasuries less the spread to calculate the market riskmap. Our hurdle for market risk is a bit less than Treasuries. We take into account retail rates that get less. At 1%, there are plenty of CDs paying 1%. It’s not a very high number, but it’s still competitive.”

Since the credit risk is relatively subdued and the market risk null, the notes have a low riskmap of 1.13, compared with an average of 1.98 for this product type. The average riskmap for all products is much higher at 3.51.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The price score for the notes is 9.92, compared with an average of 7.27 for all products and 9.56 for products of the same type, according to the report.

“The price score is very attractive. It suggests that the product has been aggressively priced, which is what you would expect because there is a very low risk for one and also because the structure is fairly transparent,” he said.

“The only option part where fees would come in is the call spread. It’s a very simple option and one that’s straightforward, easy to hedge especially on the S&P. For that reason you wouldn’t expect high fees. You get a number of S&P products out there you can compare this one to. When you only have one option like this one it’s obvious where the fees have been taken out. It’s when you get more complicated structures, or structures tied to stocks, it’s when you have more moving parts that it’s harder to isolate the cost of the options and compare the pricing with other products.”

Return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets, and high- and low-volatility environments.

The return score is calculated based on the best among the five return scenarios, which for this particular product would be the bullish scenario.

The notes have a return score of 7.21, compared with an average of 7.37 for all products and 8.12 for principal-protected notes, according to the report.

“It’s less than the other products and quite a bit less than the same product type. That’s because compared to principal-protected structures, you would normally expect a higher cap or a higher level of participation,” he said.

“But because they spend money on the 1% coupon, there is less money available to raise the cap or increase the participation rate.”

A typical principal-protected note with no coupon and upside participation over a seven-year period would allow the structurer to offer a higher cap, he said.

“This is why this product doesn’t get the opportunity to look as good under the bull market scenario that we’re using for our score,” he noted.

“If you gave up the 7% coupon, you would probably be able to raise the cap from 25% to 40%.”

Overall score

The final score generated by Future Value Consultants is the overall score. It measures the firm’s opinion on the quality of a deal and is obtained by averaging the price score and the return score.

The notes have an 8.56 overall score, compared with an average of 8.84 for products of the same type. The average overall score for all products is 7.32.

“It’s pretty average,” he said.

“It’s got some income, a bit of pocket money. It’s not like a reverse convertible paying 10%, but it’s almost the same as CD rates, although not exactly the same due to the credit risk, but at least you get the opportunity to get a 25% return in addition to your 1% coupon. It’s an instrument that’s built to outperform the risk-free rate.”

Citigroup Global Markets Inc. and UBS Financial Services Inc. are the agents.

The notes will price Oct. 2.

The Cusip number is 1730T0Z28.

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