Citi’s contingent coupon autocall notes tied to three stocks seen as risky despite 50% barrier

By Emma Trincal

New York, July 18 – Citigroup Global Markets Holdings Inc.’s autocallable contingent coupon equity linked securities due July 31, 2019 linked to the worst performing of the common stocks of Advance Auto Parts, Inc., Applied Materials, Inc. and Hess Corp. present too many risks for the potential income, in spite of a seemingly deep barrier, advisers said.

The notes will pay a contingent monthly coupon at an annual rate of 9% if each stock closes at or above its 50% coupon barrier on the observation date for that period, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par if each stock closes at or above its initial level on any quarterly valuation date after three months.

The payout at maturity will be par plus the contingent coupon unless any stock finishes below its 50% trigger, in which case investors will be fully exposed to the decline of the worst performing stock.

Plunging stock

Jerry Verseput, president of Veripax Financial Management examined the three stocks first, looking at the year-to-date performance. Only Applied Materials had posted a positive return. The two others were in a downtrend, he noted, with Advance Auto Parts showing the worst losses.

The share price of the automotive parts provider hit its one-year high in January at $177. It is now trading at around $100, he observed.

“A 50% barrier looks pretty good. But you have to look at the volatility,” he said.

Advance Auto Parts is the most volatile of the three although not by much. Its implied volatility is 38% versus 35% for Hess and 30% for Applied Materials.

But it’s mostly the price action of Advance Auto Parts that made Verseput skeptical about the notes.

From its January peak to its current price, the stock has dropped 43%.

“Can it drop another 50% in two years? I guess,” he said.

Investors should consider the previous high of $177 and not just the current price of $100 when projecting the 50% drop that represents the barrier height, he said.

“In that short period of time, the stock price has a memory. If we view it as a $177 stock, the next 50% is the real barrier. And it’s pretty close to where we are now,” he said.

Technical analysis

Such a sharp decline shows how volatile the stock is and how likely it is to move significantly, he said.

While the price could go up, nothing indicated it would not decline further, he added.

“Advance Auto Parts has plummeted. Is it all done? From a technical standpoint there’s nothing on the chart that says it’s all done.

“All it’s done so far is collapsed. It had a little jump back in May but did not break out. I need to see a bounce up. It needs to start hitting higher lows.”

Low correlation

The worst-of nature of the product added even greater risk.

The only stock which rallied this year, Applied Materials, is up 45%. But Hess is a “second loser,” having fallen by more than 30%.

“And why those three stocks? They’re in three different sectors, and because of that it only takes one sector to collapse, then you’re in trouble,” he said.

Given the volatility of the underlying securities and the worst-of payout, Verseput said that 9% a year did not offer enough return for investors.

“If you’re shooting for 9% you can get it in a leveraged note based on the Euro Stoxx very easily. It would be a much better alternative.”

Credit, fee

Steven Foldes, vice-chairman of Evensky & Katz / Foldes Financial Wealth Management, said he liked Citigroup’s credit. The credit default swap rates of this issuer are at 54 basis points. This level places the bank among the best with Bank of America’s at 52 bps and JPMorgan 50 bps, according to Markit.

Aside from credit, Foldes also objected to the notes on several points.

As a general rule, he said he does not use individual notes in structured notes.

“It’s a non-starter,” he said.

But other drawbacks applied to the characteristics of the product itself, starting with the 3.35% fee.

“We understand that the broker has to be compensated, but 3.35% is a hefty commission, and you’re talking about two years. That’s not something we like at all,” he said.

Barrier

He also mentioned a number of risks, which in his opinion should warrant a higher coupon.

The first one was market risk, which was exacerbated by the volatility of the underliers.

“You might think 50% protection is a lot, but the truth is, with certain stocks it happens and it happens frequently,” he said.

“Two years is enough time to get clobbered. If at maturity one and only one of those stocks is down 50%, you lose at least half of your investment. The potential loss is catastrophic and it’s not a 9% gain that can offset that disastrous scenario,” he said.

Early redemption

The high likelihood of an automatic call on the first determination date made the risk-adjusted return even worse, he said.

“You’re likely to see the three stocks above their initial price after three months, in which case the note gets called away. So instead of a 9% return, you’re only getting 2.25%,” he added.

The risk however remained the same: full downside exposure once the worst-performing stock hits the barrier.

Even if the notes mature, the risk of losing no less than 50% was too high in regard to the 9% coupon.

“This note is skewed toward the risk. You’re not getting the adequate return you should get,” he said.

“On top of that the fee is too high for what may become a three-month note.

“The risk-reward on this one seems to be against the investors and on the side of the bank,” he said.

Yield is risky

Foldes said he understood that this type of product may appeal to investors seeking income. But in his view, it was not the right way to proceed.

“Too often people want yield. That’s why they would buy notes like this one, the same way they buy high-yield bonds or preferreds. But you’re risking too much principal doing that,” he said.

Instead, Foldes distinguishes interest rate income from cash-flow, focusing on his clients’ needs for cash-flow through a “rigorous financial planning” process.

He then creates the desired amount of cash-flow, using interests, dividends and sales proceeds of limited parts of the portfolio.

“We sell only a small part and we expect that our diversified portfolio will grow and make back whatever has come out to provide for the necessary cash-flow needed for retirement,” he said.

The danger with income-seeking notes, he said, was that too much of the principal is at risk. In general and in this example in particular the balance between risk and reward is not favorable to investors, he concluded.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Holdings Inc. is the underwriter.

The notes will price on July 26.

The Cusip number is 17324CKZ8.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.