Citigroup’s leveraged buffered notes linked to ETF basket offer debatable diversification

By Emma Trincal

New York, Feb. 12 – Citigroup Global Markets Holdings Inc.’s 0% market-linked notes with leveraged upside participation to a cap and fixed percentage buffered downside due March 6, 2023 linked to an unequally weighted basket of exchange-traded funds provide investors with diversification across regions. But a buysider said the portfolio is unbalanced given the heavy U.S. component.

The basket consists of the SPDR S&P 500 ETF trust with a 50% weight, the iShares Russell 2000 exchange-traded fund with a 15% weight, the iShares MSCI EAFE exchange-traded fund with a 15% weight, the iShares MSCI Emerging Markets exchange-traded fund with a 10% weight, the Invesco DB Commodity Index Tracking Fund with a 5% weight and the Vanguard Real Estate ETF with a 5% weight, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par plus 125% of any basket gain, capped at par plus 42% to 47%. Investors will receive par if the basket falls by up to 15% and will lose 1% for each 1% decline beyond 15%.

Unbalanced

The U.S. equity asset class, which includes the Vanguard Real Estate ETF, represents 70% of the basket, the buysider noted.

“You only have 25% in international stocks. Everything else, except the tiny and insignificant commodity exposure, is in U.S. equity. It’s not really balanced. I’m not crazy about it because the U.S. market is the most expensive in the world,” he said.

This buysider said he is concerned about the risk of a recession in the United States over the next two years. In his opinion, the U.S. market is already at the beginning of a trend reversal.

Downside risk

“The S&P has been in a long bull cycle for a decade. If we go from today’s levels back to the lows of 2009, in real terms the drop would be more than two-thirds,” he said.

This estimated drawdown was based on a chart of the S&P 500 index measuring historical prices on an inflation-adjusted basis.

“Even if the emerging markets and Europe do well during that time, the basket is so heavily weighted in the U.S. that we could be down more than 15% quite easily,” he added.

“It’s nice to have a buffer, but it would be nicer to overweight outside of the U.S.”

Value abroad

He said he favored the other basket components for their valuation.

“Unlike the U.S. market that has tripled since 2009, emerging markets have basically stayed unchanged. Europe has been up only a little bit. It has a much greater chance at generating positive returns over the next four years,” he said.

When mentioning Europe, he was referring to the iShares MSCI EAFE ETF, which is often used as a proxy for that region. European stocks account for more than 60% of the EAFE fund.

Cap, buffer

The 42% to 47% cap range was “decent,” he noted. If set at midpoint, the 44.5% cap would represent a maximum compounded return of 9.65% per year.

“That’s reasonable, and it’s fair if you provide a 15% buffer. I’m just not convinced that 15% is going to be enough protection,” he said.

“The fact that this basket is heavily invested in the U.S. is a big negative. I prefer to invest international.

“If it was based on Europe and emerging markets, I would be more inclined to participate.”

Convenient

Tom Balcom, founder of 1650 Wealth Management, was not concerned about the U.S. weighting.

“It’s basically a U.S.-centric note. It’s a global allocation with 25% going to international equity,” he said.

To him, the international component was a way to diversify away from a pure U.S. allocation.

“It’s a good trade for diversification. It’s also very convenient for an asset allocator. You can buy it, put it in your global allocation and call it a day.”

Mild bulls

The only “downside” was the cap.

“It’s not for everyone. You can’t buy this if you’re a bull. Even though it’s almost 10% a year, if you’re really bullish you’re probably going to think the cap is too low.”

This decision regarding the cap derives from an investor’s outlook.

“There is always a trade-off. The cap is there for a reason. If you want to have exposure with a buffer, that’s the right product. If you think the cap is too low, you probably don’t need the buffer and this note is not for you,” he said.

Better than a worst-of

Asked whether he thought a 15% buffer would provide adequate protection, he said, “I have no idea what the market will be like four years from now. But it certainly is nice to have a 15% buffer rather than a 0% buffer.”

Another positive aspect of the product was the payout structure.

“It’s a nice change to see something that’s not a worst-of. It’s a simple basket. If we have a pullback, you want to be in a basket. You wouldn’t be happy in a worst-of. The main benefit of the note is that it provides diversification.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on Feb. 28.

The Cusip number is 17326YHT6.

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