Citigroup’s notes linked to Euro Stoxx have no cap, but downside risk is issue despite barrier

By Emma Trincal

New York, Feb. 19 – Citigroup Inc.’s 0% contingent buffered notes due Aug. 24, 2016 linked to the Euro Stoxx 50 index offer several attractive features, sources said, pointing to the uncapped upside, short duration and contingent protection.

But the risk associated with European equity markets may have justified a buffer instead of a barrier, an adviser said, while another expressed concerns about the underlying asset class, pointing to currency and political risks in the euro zone.

The notes offer no leverage and no cap. Investors simply get a one-to-one exposure to the index on the upside, according to a 424B2 filing with the Securities and Exchange Commission.

On the downside, investors are protected above a 78.1% barrier level at maturity. If the final index level is below the 78.1% threshold, they are fully exposed to the index decline from its initial level.

No cap, no buffer

“The structure is such that you don’t want to give up the upside because you’re not willing to put a cap. But you’re getting a barrier that can be breached after a 22% decline,” said Steve Doucette, financial adviser with Proctor Financial.

“We always like to look at these notes as ways to outperform on both sides. I don’t see that here. My preference would go for a plain buffered note even if it’s a small buffer.”

Doucette said that even if the 22% amount of downside protection appears to be generous, it is only a barrier, not a buffer.

“It’s a contingent protection. Once you go below that, you don’t have any protection at all,” he said.

Getting a buffer instead of a barrier would be his priority.

“Why not deal with a cap and sell some of that upside, which will provide me purchasing power to purchase protection and put a buffer on it?” he said.

Opportunity cost

The non-payment of dividends – the Euro Stoxx 50 has a 3.77% annualized dividend yield – reduces the value of the barrier level if one compares the notes’ potential performance with that of the Euro Stoxx 50 equity fund. On a one-and-a-half-year term, investors in the notes would be “missing out” on 5.65% worth of dividends. A shareholder in the fund, on the other hand, would be able to use this amount as a small buffer, he noted.

“The way the deal is structured is confusing. You want to be long, but you don’t get the dividends. And you can only outperform within a range on the downside if the index drops by less than 22%. It’s almost like a bearish bet if your only way to outperform is on the downside,” he said.

Given the 5.65% gap in performance between the notes and the fund, the range within which the notes would outperform the index on the downside ends up being even narrower than 22 percentage points, he noted.

“I understand that investing in the fund would not give me the protection. But with this note, you’re almost guaranteed to underperform the fund except within a narrow range on the downside,” he said.

“It’s because you’re giving up so much in dividends that they’re able to price on such a short-term product the no-cap and the barrier.”

Mean reversion

Doucette is interested in the asset class, however.

“It makes sense,” he said.

“A lot of the financial news keeps on repeating that the U.S. is the only safe place to put your money.

“But look at the outperformance of the S&P over international and emerging markets. You’ll see a huge disparity, and I’m a firm believer in mean reversion. So what does it mean? Either the S&P will go down or the Euro Stoxx will go up, or both.”

For the past 12 months, the S&P 500 has performed the Euro Stoxx 50 with a 15% return versus 7% for the euro zone benchmark. But so far this year, it’s the other way around with the Euro Stoxx 50 up 5% against 2.2% for the U.S. benchmark.

“From a valuation standpoint, it makes sense. And you may think from that standpoint that 22% on the downside is enough. But it’s only a barrier,” he said.

“The average bear market is 20% decline. Bear markets tend to overshoot the average. It has nothing to do with valuation. Once you get in that direction, it’s an emotional response to the market going down.

“So I wouldn’t use that type of deal without a buffer.”

Tail risk

Matt Medeiros, president and chief executive of the Institute for Wealth Management, said the risk-reward associated with the asset class is a concern.

“Europe presents some interesting opportunities, but it’s also a vulnerable market. You run into a series of potential problems that can trump any good investment analysis. If Greece and Germany cannot come to terms with the debt issue, that would have a major impact on Europe in terms of currency risk and volatility,” he said.

“Valuation is interesting in Europe, but the potential for crises is also significant,” he added, pointing to the Greek debt debacle and the ongoing conflict in Ukraine despite the recent ceasefire.

“We just saw Russian warplanes getting very close to Britain and the Royal Air Force having to escort the bombers off its coast. It’s Russia doing a show of might.

“So there are a number of risks when it comes to Europe and serious risks. In fact, you can say there is a big tail risk. As an investor, it’s hard to commit to the euro zone.”

The structure of the notes is “interesting,” he said.

“I like the fact that it’s short-term, but I’m nervous about the euro zone.

“The impact of potential social and governmental crises could lead to a surge in volatility, which may overrule the great opportunities offered by the local markets.

“Even if the Euro Stoxx index fund is trading at a relatively good value, there are other places to spend your risk capital that make more sense, such as the U.S.”

Citigroup Global Markets Inc. is the agent with J.P. Morgan Securities LLC and JPMorgan Chase Bank, NA as placement agents.

The notes will price Friday and settle Wednesday.

The Cusip number is 1730T05D7.

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