Citi’s digital notes tied to Euro Stoxx 50 would beat mildly bullish market, but some see risk

By Emma Trincal

New York, Oct. 19 – Citigroup Inc.’s 0% barrier digital securities due Oct. 26, 2017 linked to the Euro Stoxx 50 index offer protection for those seeking exposure to European stocks and possibly excess return if the index growth is moderate, a buysider said. But the risk associated with this benchmark is substantially high, and the protection may not be adequate, another noted.

If the final index level is greater than or equal to the initial level, the payout at maturity will be par plus the fixed return amount, which is expected to be 18% to 21% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is less than the initial level but greater than or equal to the barrier level, 80% of the initial level, the payout will be par.

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

Change of heart

Carl Kunhardt, wealth adviser at Quest Capital Management, said the notes reflect his moderately bullish view on the Euro Stoxx 50’s performance and offer a substitute for an international equity allocation with less risk than having a position in the index outright.

“I used to be very bullish on non-U.S., international equity, particularly on Europe. But I’m not as bullish anymore,” he said.

“Earlier this year, they announced all sorts of changes, there were talks about a deal with Greece, about shoring up France, but they have done nothing except a first round of quantitative easing. It’s all talk again.

“So I am a lot less optimistic about Europe, which makes a digital note with some good protection relatively attractive.”

A must

Another reason for his interest in the product is related to his asset allocation principles.

“We try to keep an allocation to all major asset classes, and clearly, non-U.S. developed markets is one of those major asset classes you have to be exposed to. There are other large non-U.S. developed markets in the world, but Europe is the most important one,” he said.

“Australia is not that huge. Japan is not that impactful anymore. China and most of South America are emerging markets excluding Mexico maybe, but Mexico, just like Canada, is correlated to the U.S. because of Nafta.”

Signed in 1992 by the United States, Mexico and Canada, the North American Free Trade Agreement, or Nafta, established a free trade zone in North America.

“Therefore when you talk about non-U.S. equity, you find yourself pinned down in a corner. You can’t avoid Europe. You can’t ignore it from a strict asset allocation standpoint. At the same time, I get the feeling that Europe is not going to do very well. So how do I get an exposure without taking undue risk?

“This note seems to offer an answer.”

Good terms

Kunhardt pointed to some of the aspects of the deal he finds attractive.

“Two years is not very long,” he said.

“The Euro Stoxx is a concentrated index, but these are the big boys. You’re dealing with the multinational companies. Most of their revenues is going to come from outside their own country.

“I give up some of the upside, but it’s a digital. To get my 18% to 20%, I don’t have to see the index go up at all. As long as it’s not down, I’ll get my digital payout.

“I can get equity-like returns even if the index doesn’t generate equity-like performance.

“And I have a pretty generous barrier.”

Digital

Michael Kalscheur, financial adviser at Castle Wealth Advisors, said the return potential is attractive.

“If the returns are muted, this would outperform the index,” he said.

“It’s a digital, and normally I’m a little bit shy on digitals. But the range they’re quoting – 18% to 21%, or 8.5% to 9% if you’re compounding – is very generous.

“The best thing about a digital is that you get this return even if the market is up only 0.1%. So with an average market, you will not only keep up with the market, you will beat the market.

“If you’re slightly bullish but not greatly bullish, this is pretty good.”

Neat, fair price

He mentioned other positive features.

“It’s a very straightforward note ... similar to the Dow Jones industrial. It’s based on the 50 largest companies in Europe. There’s a certain ease of explaining it to a client,” he said.

“The fee is fair. You’re talking 50 basis points a year. That’s the kind of fee I like to see.’

The fee is 1%, according to the prospectus.

“We like the pricing of it, but the terms of it are a bit disappointing.”

No great credit

Kalscheur first pointed to the issuer’s credit risk. While two years is a short period for credit risk exposure, the issuer is not on the top of his list, he said.

“We’ve been very hesitant about using notes issued by Citi just because they almost went under in 2009. They have high CDS spreads. They’re still on my list, but they’re the last ones on my list. I would be much more inclined to go with somebody like Wells Fargo, HSBC or JPMorgan,” he said.

Volatile underlier

By far, however, his main concern is the protection feature.

“It’s a barrier, not a buffer. I realize that you probably can’t get a buffer on a two-year, but this is a volatile underlying. The Euro Stoxx has been down more than 20% in a two-year period in recent history.”

As an example, during the bull market that followed the 2008 crisis, the Euro Stoxx 50 dropped 28.5% between December 2009 and December 2011.

“To have 100% of the downside if you’re under 20%, I just can’t get excited,” he added.

Kalscheur said the note does not pass the test he always uses to get a sense of the risk-return profile of a note.

“My rule of thumb is I want to have two wins out of three. Here I only have one win,” he said.

“If the European stock market is terrible or if it shoots the lights out, I lose. I only win when the market is normal. In the two other scenarios, bullish or bearish, this thing is going to underperform.”

Pricing question

Kalscheur said that he is surprised not to get better terms when the fee is so reasonable.

“You have a 3.5% dividend on this index. It’s huge,” he said.

“For an issuer that has plenty of spread on its CDS and this enormous 7% yield to play with, there’s plenty of income to buy good terms, especially when you’re not wasting that money on fees. The fees are fair. So why can’t we get a buffer or better terms?

“Twenty percent of protection may seem pretty good, but with this index, the risk of breaching this barrier is real.”

The three-year standard deviation of the Euro Stoxx 50 is 16.08%, compared with 9.72% for the S&P 500 index, he noted.

“Maybe it’s because this particular underlying is too volatile, making the protection on the downside on this short period of time just too expensive,” he said.

Longer is better

In such case, Kalscheur said that he would strongly prefer a longer-dated product, a five- or six-year term note instead of a two-year term.

“You’re more likely to breach a 20% barrier in two years than in five years. A 20% barrier for five years is more palatable to me,” he said.

The upside may also have been a factor in limiting protection.

“The digital is generous over a short period of time, and so to generate that coupon, they has to limit the protection on the downside I suppose,” he said.

But in his view, protection comes first.

“One of the reasons we invest in structured notes is to get that downside protection. It’s a very important piece of the puzzle and not something we’re willing to give up,” he said.

“The volatility of the Euro Stoxx has to be taken into account. To us this barrier is just not enough.

“Over the past five years, the Euro Stoxx has been more volatile than the S&P. Performance has not been there.

“You can make a strong contrarian argument and bet on the Euro Stoxx, taking a mean reversal look at it. But the terms are still not good enough for me to tie my money up. I would rather be in cash or commit to more time with more protection.”

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price Friday.

The Cusip number is 17298C3M8.

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