Citigroup’s $11.23 million barrier notes on three indexes show novel, hybrid worst-of payout

By Emma Trincal

New York, March 30 – Citigroup Global Markets Holdings Inc.’s $11.23 million of 0% barrier securities due Sept. 28, 2023 linked to an equally weighted basket of the S&P MidCap 400 index, the Nasdaq-100 index and the S&P 500 index offer an innovative structure combining a basket-linked return on the upside with a worst-of exposure on the downside. While the upside is capped and levered, the exposure, once the barrier is breached is on a one-to-one basis.

The payout at maturity will be equal to the sum of the basket return amount and indexed principal amount, according to a 424B2 filing with the Securities and Exchange Commission.

If the final basket level is greater than its initial level, the basket return amount will be par plus 2 times the basket return up to a maximum of par plus 50%. Otherwise, the basket return will be zero.

If the final value of the worst performing index is greater than or equal to the barrier level, 70% of the initial level, the indexed principal amount will be par. If the worst performing index finishes below the barrier level, the indexed principal amount will be par minus the loss of the worst performing index.

Carl Kunhardt, wealth adviser at Quest Capital Management, was not impressed by the hybrid nature of notes with its worst-of payout only applicable to the downside. In his view, market capitalization and market cycles were more relevant.

“In this environment of massive volatility, you can set the S&P 500 index and even the S&P MidCap 400 index aside. They’re not the driver. The driver is going to be the Nasdaq because it’s much more small-cap,” he said.

Nasdaq play

The constituents’ weights in the Nasdaq are based on their market capitalizations, but certain rules limit the weight of the largest components.

“If you think the economy will take off, the Nasdaq will drive the recovery. If at the contrary you think we’ll go through a recession, the Nasdaq will be the worst of the three,” Kunhardt added.

“It is a play on the Nasdaq because this is what will lead us into both uptrends and downturns,” he said.

The question every asset manager is asking amid this coronavirus pandemic is how much more market decline lies ahead.

Great Depression lessons

“We are at an inflection point right now. We’re testing the downside,” he said.

Any investor buying the notes need to be confident that the barrier will not be breached by the worst-performing index at maturity, he added.

Unfortunately, the current crisis and the political responses it generated are making most predictions impossible, he said.

“Where do you expect to be in three-and-a-half years? I expect to be fully recovered.

“So, did the people in 1929. The crash was over very quickly. But by 1930, Hoover, a Republican raised the tariffs. “The Fed tightened monetary policy. That’s what led to the great Depression.”

Today’s political responses, while different, remain worrisome, he said.

“We’re in a new reality,” he said.

“The Congress just voted for a $2 trillion fiscal stimulus package. The Fed has over $5 trillion on its balance sheet. How in the hell do you manage that? That’s the question nobody wants to ask.”

Worst-of is moot

Kunhardt minimized the importance of the worst-of on the downside.

“It doesn’t make much difference because all three indices are highly correlated. Anytime the market goes down, correlations between assets increase,” he said.

“The only time you have less correlation is during an inflection point, for instance when you go from the downside to the upside, in which case the large-cap would be the worst-of,” he said.

“But that’ just during a limited period.

“So, correlation is moot. They pretty much all move together.”

If on the other hand, the inflection point is a move from a downtrend to an uptrend, the dispersion risk associated with the worst-of would lose its impact since the upside payout on the notes is based on the diversified final basket level not on the worst-performing index.

Magic

“I don’t think this is a particularly innovative structure to tell you the truth,” he said.

“It’s still a worst-of.”

“When a magician does a trick, the trick is not that hard. They do it from the left hand while drawing your attention to the right hand.

“This is just a worst-of.

“They’re drawing your attention to the basket on the upside. But it’s just a distraction.

“I wouldn’t do it not because it’s a worst-of but because of my macroeconomic outlook. We have more lows to test before we go back to a healthy bull market.”

Lower levels

Jeff Pietsch, founder of Eastsound Capital Advisors, said the notes could be attractive to some investors.

“I like the leverage on the upside. The 50% cap still gives you a decent double-digit return,” he said.

“Looking at capital market assumptions going forward, we don’t have a lot of visibility. But given that the major averages are already down 20% to 30%, we’re probably closer to the bottom than to the top.

“I kind of like it.”

Pietsch said he liked the underlying basket, especially the Nasdaq.

“So far, the Nasdaq has been the safer play. It’s comprised of stocks of companies, which have high cash reserves, high profit margins and can adjust to supply chain disruptions.

“The note is not a bad bet compared to just being long the three indices,” he said.

Barrier

The risk associated with a worst-of on the downside was somewhat offset by the extent of the current bear market, he said.

“I’m not too worried about breaching the 70% barrier.

“That’s not to say that I believe the market will rebound quickly.

“It will be more of a U-shape recovery rather than a V-shape recovery.

“There are probably further declines ahead. But in three-and-a-half years, I don’t think we will be down another 30% given how much the market had dropped so far.

“For an individual investor looking for equity exposure this might be a worthwhile trade-off,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 17328VAC4) priced on March 24 and settled on March 27.

The fee is 0.4%.

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