Citigroup’s buffer securities on Dow ETF to show lower-risk alternative to fund, analyst says

By Emma Trincal

New York, July 26 – Citigroup Global Markets Holdings Inc.’s 0% buffer securities due Aug. 30, 2024 linked to the SPDR Dow Jones Industrial Average ETF Trust, give investors one-to-one exposure to the U.S. large-cap market with substantially less risk, said Suzi Hampson, head of research at Future Value Consultants.

If the final ETF level is greater than the initial ETF level, the payout at maturity will be par plus the ETF return, subject to a maximum return that is expected to be 50% to 55% and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission. Investors will receive par if the ETF declines by up to 20% and will lose 1% for every 1% that it declines beyond 20%.

Some advisers inclined to be bullish may see the lack of upside leverage combined with a cap almost as an anomaly, she said.

“When you have a long-term product, one-to-one doesn’t seem very exciting. You’re getting back the underlying performance limited to a maximum return. You’re not getting the dividends. You can’t outperform the index on the upside. At first you may think: why not invest in the ETF itself?” she said.

“However, we do have this buffer, which is quite generous. On the downside at least you still get a much better return than the fund.

“You’re giving up the upside above the cap and the dividends. In exchange, if things go wrong, you have the protection. That’s the tradeoff. It’s an alternative to the ETF,” she said.

Because the “alternative” presents less risk, investors should not expect higher returns, she said.

Still, assuming a 52.5% cap at the midpoint of the range, the maximum return would be 8.81% per year on a compounded basis.

“You’re limited to the cap. But the cap isn’t bad in itself,” she said.

Overall, the product is designed for cautious, conservative investors seeking participation in the Dow Jones Industrial with less volatility.

“No dividends, limited upside, limited liquidity...I can see that it would be a problem for a bull. It’s a lot of negatives. The biggest plus is the 20% buffer,” she said.

“For a long-term investor, this type of product has a place in a portfolio though. You’re locking in for five years but long-term investors don’t look for short wins. It’s not very exciting. It’s not tied to a stock or an exotic underlying. But it does the job of reducing risk and volatility in your large-cap allocation.”

Capital performance tests

Future Value Consultants offers stress testing on structured notes allowing investors to determine the probabilities of outcomes pertaining to a specific product and structure type.

Each report includes 29 tests or tables. Hampson focused on one of them called “capital performance test.”

For this particular test, the model displays results associated with five different market scenarios. First, the neutral scenario, which is not used to predict outcomes but rather reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying. The four other market assumptions used for the simulation are based on relatively conservative index growth rates and volatility assumptions. The scenarios are – bullish, bearish, less volatile, more volatile.

Bull in name only

In the neutral scenario, the chances of “return more than capital” on the one hand and “return exactly capital” or “less than capital” on the other hand, are approximately 50/50, she said commenting on the probabilities of 52.7% and 47.3%, respectively.

“It’s pretty symmetrical. Either you’re above 100 or you’re below,” she said.

“This doesn’t tell us much because the neutral is more of a pricing scenario. What should really be looked at is the bull.”

Even the bull assumption is very conservative, she said. The underlying is hypothetically going to grow at a rate of 4.9% a year. That’s the rate established by the Monte Carlo model on the basis of the firm’s methodology.

“The bull scenario is not very bullish,” she said.

One could say the bearish scenario is not very bearish either. It carries a hypothetical return of minus 5.1%.

Those low-growth assumptions are part of the model’s methodology, she explained and are designed to facilitate comparisons between products. Yet probabilities change noticeably from the neutral to the bullish scenario.

The “return more than capital” outcome has a 78.66% probability of occurring in the bull scenario. The chance of getting “exactly capital” (fund price between 80 and 100) is 11.8%, which indicates how often the buffer will serve to eliminate all losses.

“This product will perform best under the bull scenario. This is what you would hope to achieve,” she said.

The “return less than capital” bucket is associated with a 9.54% probability, which is significantly less than 25.8% in the neutral or 49.07% in the bear, according to the table.

“What doesn’t come out is the magnitude of your losses. But we can assume that compared to a barrier, a smaller buffer or a geared buffer, your losses should be much lower.”

Risk and time

Future Value Consultants also offer back-testing analysis for the past five, 10 and 15 years.

Those reports should not be solely used to make investment decisions though, she warned.

Many advisers consider that a large buffer on a longer-dated note is unnecessary because they assume that risk diminishes with the duration of the note, according to interviews with Prospect News. Hampson disagreed.

“If you look at the back-testing, maybe. But just because it happened before doesn’t mean it’s going to happen again.

“In terms of longer-term being less risky, from a simulation’s point of view...that’s just not the case.”

Back-testing

To be sure, the report’s back-testing reveals a very different picture than the simulation. 100% of the time, investors would receive more than capital over the last five years. This frequency declined somewhat over the 10-year stretch as the period is still close to the immediate aftermath of the Great Recession. For that longer period, the frequency for gains was 81.41%.

Overall, however, even the Monte Carlo simulation showed that the structure of the notes reduces risk significantly compared to the fund.

“For capping your upside at 9% a year and giving up dividends, you get a 20% buffer, which will make you outperform the underlying if the market is down,” she said.

“This product is a balanced, lower-risk alternative to the ETF.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price Aug. 27.

The Cusip number is 17324XQG8.

© 2015 Prospect News.
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