Citigroup’s barrier enhanced digital plus on Stoxx Europe 600 to outperform in sideways market

By Emma Trincal

New York, Jan. 30 – Citigroup Global Markets Holdings Inc.’s 0% enhanced barrier digital plus securities due Feb. 27, 2023 linked to the Stoxx Europe 600 index offer access to a lesser used European benchmark in the United States as well as potential excess return if the market trades range bound, sources said.

If the index finishes at or above the barrier level, 80% of the initial level, the payout at maturity will be par plus the greater of the fixed return amount of 33% and any index gain, capped at 60% to 70%, according to a 424B2 filing with the Securities and Exchange Commission.

The exact cap will be set at pricing.

Otherwise, investors will lose 1% for each 1% decline of the index from its initial level.

Cost of return enhancement

“This note may work for someone with a sideways view on the European market. But it’s a tradeoff,” said Jonathan Tiemann, founder of Tiemann Investment Advisors.

“You’re selling a put for the digital return, which allows you to outperform in a range between 80% and 133% but your degree of alpha diminishes as you get close to 133%.”

Tiemann said that noteholders “pay” for the digital boost with the unpaid dividends, as well as the “illiquidity.” He considers the product fairly “illiquid” due to its longer-dated tenor as well as the limited liquidity in the secondary market, of which most filings including this one warn investors.

“This would apply to most five-year notes,” he said.

The “cost” of the dividends represents approximately 15.80% for the term, according to the prospectus, which used a recent annual dividend yield of 3.16% and assumed no reinvestment of dividends.

Middle of the staircase

Compared to holding the straight debt of Citigroup, investors are not receiving any coupon and their principal is at risk, he added.

“You pay with the dividends, the illiquidity and the cost of capital. And now that you sold the upside, you get this sort of landing in the middle of a staircase.”

He explained what he meant: the real area of outperformance without taking into account the dividends is between the barrier and the digital level. Anything below and above this 53 percentage points band will either provide a long exposure to the index (below the barrier or between the digital level and the cap) or a lower performance compared to the index when returns get capped.

“That said, if your view is that volatility is overpriced, the note could be interesting in that regard,” he said.

“You don’t want to invest in this if you’re bullish. But if you want the exposure to this index and if you think it’s going to trade sideways, it may be worth it.”

Digital benefit

Clemens Kownatzki, independent currency and options trader, said the structure offered some benefits although he was not comfortable with the tenor and timing of the investment.

“Obviously this note has an attractive feature: being able to get a 33% return if the index is down 19% is very attractive.

A 33% return over five years is 5.8% compounded annually, he noted.

“It’s not bad,” especially if the index is down.

Market risk

But Kownatzki’s main objection was the market risk on the downside.

“There is no limit to the downside once you breach the 80% barrier,” he said.

It is impossible at this point in the market cycle to tell whether 20% in contingent protection will be enough at maturity.

“You’re trying to predict the future five years out. That’s a concern,” he said.

A correction “will happen,” he said, pointing to “eight years of a bull run with no real correction, volatility levels at historic lows and market participants systematically ignoring bad news.”

The risk of a correction happening at maturity was always a possibility.

“Are we going to have another five years of a bull run? You’re reading the tea leaves,” he said.

Without proper risk management the risk would be too high.

“I could buy a put although the time value is long and it would be expensive,” he said.

Another expense to pay attention to is the 3% underwriting fee.

“It’s a high cost, which would add to the cost of adding protection, and while it seems entirely justifiable, it adds up,” he said.

Access

For the right investor, however, the notes may be beneficial.

“If you are a long-term investor and if you’re only mildly bullish this may not be a bad idea,” he said.

The index itself offered the benefit of diversification.

“It’s widely diversified not just across 600 stocks but also across countries and sectors, he noted.

“From a diversification standpoint, it’s not a bad deal.”

Another positive point was the difficulty faced by U.S. investors to get exposure to this particular index.

Several ETFs linked to European equities are available. The most common one from State Street Global Advisors is linked to the Euro Stoxx 50. But this benchmark is more concentrated than the Stoxx Europe 600 index.

Another well-known fund, the Vanguard FTSE Europe ETF tracks a different index called the FTSE Developed Europe All Cap Index. In this case the universe is much wider with 1,285 components.

“In that regard the notes could be seen as an access play,” he said.

Citigroup Global Markets Inc. is the underwriter.

The guarantor is Citigroup Inc.

The notes will price on Feb. 22.

The Cusip number is 17324CR57.

© 2015 Prospect News.
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