Citi’s $4.79 million best-of brings novelty, but advisers object to asset mix, dividend ‘loss’

By Emma Trincal

New York, Feb. 15 – Citigroup Global Markets Holdings Inc.’s $4.79 million of notes due Feb. 8, 2027 linked to the best performing of two baskets, one focusing on equities and one on bonds, offer a welcome and rare example of a “best-of” payout compared to the all-pervading “worst-of,” advisers said.

Each basket is composed of the same equity indexes, bond exchange-traded funds and commodities, but the weightings of the components within each basket differ, according to a 424B2 filing with the Securities and Exchange Commission.

The equity-focused basket gives a 65% weight to the equity components, 17.5% to the bond components and 17.5% to the commodities components. The bond-focused basket gives a 65% weight to the bond components, a 17.5% to the equity components and 17.5% to the commodities components.

The payout at maturity will be par plus 1.35 times any gain in the best-performing basket.

Investors will be exposed to any decline in the best-performing basket.

The underlying components are the S&P 500 index, the Euro Stoxx 50 index, the Nikkei 225 index, the MSCI Emerging Markets index, the iShares 20+ Year Treasury Bond ETF, the iShares Core U.S. Aggregate Bond ETF, the iShares iBoxx $ High Yield Corporate Bond ETF, the iShares J.P. Morgan USD Emerging Markets Bond ETF, gold futures and Nymex light sweet crude oil futures.

Balanced portfolios

“You don’t see that every day! A note linked to the best performer on the basis of two well-diversified baskets,” a financial adviser said.

He noticed the full downside risk at maturity.

“I guess the argument is you don’t need the protection since it’s a well-diversified basket and of course you get the return of the best one.

“If equities do horribly, you have the bonds. If neither one of them does well and we’re in an inflationary scenario, you have the commodities.”

Yield, leverage

One caveat: investors are giving up income, he noted.

“Between the bonds that pay fairly low interest rates and the equity dividends, my guess is you’re giving up about 2% a year...give or take 10% for the period,” he said.

One way to offset the non-payment of income and dividends is the upside leverage.

“That’s the tradeoff. Are you willing to give up that 10% yield for the 35% leverage? If the return is muted, you barely break even,” he said.

Over-diversification

The risk-adjusted return may also suffer from over diversification, he noted.

“This is a portfolio that cuts out the bottom, but it also cuts out the upside. The diversification reduces volatility, that’s what diversification is designed for. But in addition to that, you’re not getting any yield. Is this worth investing in a note for five years with no downside protection, no dividend just for the best-of and the bump on the upside?” he said.

Setting expectations

Another issue was communication with clients.

“There are so many moving parts. You can’t run an analysis here. It’s more of a gut feel,” he said.

In addition, the portfolio is “static” and will not change.

“You can’t change it. Your money is locked up for five years,” he said.

“I can build a diversified portfolio all by myself and rebalance it myself.”

This adviser tends to back test individual indexes when purchasing a structured note linked to an equity benchmark, which he favors. The nature of the two underlying baskets and the best-of feature made risk analysis nearly impossible, he said.

“It’s difficult in those conditions to set expectations. You’re taking the risk that clients will be disappointed in five years. If you, the adviser, can’t figure out what type of risk you’re taking, how could you convince a client?” he said.

Some risky bonds

Steven Foldes, wealth manager and founder of Evensky & Katz / Foldes Financial Wealth Management, said he was not interested in the product.

“It’s an interesting attempt on the part of Citigroup to offer the opposite of a worst-of, and I like the credit of this issuer,” he said.

“But I can’t say I love the note. Number one, we don’t like five-year notes. Second, they created two asset allocation models, which preempt what we do for our clients,” he said.

Foldes said he does not invest in 20-year bonds, which represents 32% of the bond-focused basket.

“That’s a very high weighting,” he said.

Similarly, he does not use junk bonds due to their high volatility and correlation to stock markets.

In 2008, the iBoxx High Yield ETF dropped 30%.

The 17.5% weighting in commodities was also too elevated, he noted.

Too high a cost

“They supplanted us in terms of making an asset allocation, which we don’t like.

“You are giving up too much yield on a five-year basis.

“As much as I like the idea of an exposure to the best performing basket, it’s expensive to give up between 2% and 3% in annual yield,” he said.

The 135% participation fails to compensate investors for the non-payment of dividends, he said.

“This is something I would stay away from.”

The notes are guaranteed by Citigroup, Inc.

Citigroup Global Markets Inc. is the agent.

The notes settled on Feb. 9.

The Cusip number is 17330AH21.

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