Citigroup’s $1.64 million worst-of tied to three stocks show solid barrier, risky dispersion

By Emma Trincal

New York, March 1 – Citigroup Global Markets Holdings Inc. priced $1.64 million of autocallable contingent coupon equity-linked securities due Feb. 28, 2019 tied to the worst performing of the common stocks of Valero Energy Corp., Bank of America Corp. and Nordstrom, Inc., according to a 424B2 filing with the Securities and Exchange Commission.

The notes will pay a contingent monthly coupon of 9.75% per year if each stock closes above its 50% barrier on the observation date for that month.

The notes will be automatically redeemed at par plus interest if each stock closes at or above its initial price on any quarterly observation date beginning in May 2017.

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

Barrier, basket

“The barriers are deep, so that’s good,” an industry source noted.

“Can you see a 50% drop in any of those three stocks? People would probably say no, it’s not likely unless something major happens.

“But it’s a crazy basket. It’s not cohesive. It looks like there’s high dispersion on the three names.”

He was referring to the likely divergence in the respective performance of the stocks due to a low correlation between the three assets.

Valero is an oil stock trading near its 52-week range at $68.50 a share.

Bank of America is a bank stock, whose price has jumped up 13% this year.

Nordstrom is a fashion specialty retailer.

“You’ve got three totally different names in three totally different sectors,” he said.

Retail

“With a worst-of, you have to have a view on each of the stocks. I would be mostly concerned with Nordstrom.

“We haven’t had good news on retailers, and if Trump imposes a trade tax, it may squeeze margins or force people to pay more. Then there’s always the risk to see customers bring their business elsewhere or cut their spending.”

Nordstrom traded at around $45.00 a share on Wednesday. The stock peaked in December at $61.00, he noted.

“Could it go down 50% from where it’s at right now? Everything is possible. That would be a price of $22.00, and it was trading near $36.00, $37.00 last June. It hasn’t dropped down to the 20’s but it’s approaching those levels. So yes, it can happen especially over the next two years.”

Yield

On the other side, the 9.75% was generous.

“You have to weigh that out. Are you willing to take that risk for this type of return? For the most part, you’re likely to get your coupon,” he said.

Investors buy the low barrier note on the view that they will be able to collect the coupon several times until the worst-performing stock hits the barrier if it ever happens.

“This trade is clearly for someone shopping for coupon,” he said.

“Any client who comes to me and say: I need a 10% return, find me a stock to do it... the client approves the risk and it gets done.

“This one is no exception. But with a correlation nowhere near one, it’s quite speculative,” he said.

Worst-of options

Issuers use worst-of payouts as a way to boost the yield on income products when volatility is low, a structurer said. With multiple underliers, the worst-of option will be worth more when the assets are not highly correlated or when the correlation is negative, allowing as a result investors to get a higher return, this structurer added.

He offered an illustration but warned that his example was an “oversimplification” of the process.

Taking the example of two stocks A and B as the underliers of a note, he said that creating the worst-of was the equivalent of selling a put on A and selling the underperformance of B versus A.

Those positions reflect a view in which stock A will not drop below a certain level; secondly the investor is selling the worst-of option implying a bet on the divergence in performance between the two stocks A and B.

If A drops 10%, the trade loses 10%. If B decreases by 20%, the divergence between the two stocks creates an additional 10% loss.

“You already lost 10% on the A put sale and you have another 10% due to the differential between the two.

At the end, you lose 20% which is the exposure to the worst stock,” he said.

“Again, this is ultra-simplified. In reality you don’t use options. You use probabilities that you plug into a Monte Carlo model. Many other contingencies play out in the real world.”

But he used this simplistic example to illustrate the relationship between high premium and the lack of symmetry between two underliers.

“The less correlation between the two stocks, the more juice, or premium you get as an investor. Worst-ofs make a lot of sense when volatility is low like it is now,” he said.

“If the two stocks always moved symmetrically, if A was moving in sync with B you wouldn’t pay me anything on the worst-of option.

“The more risk you take on these dispersion bets the more premium you get.”

Citigroup Global Markets Inc. was the underwriter.

Citigroup Inc. is the guarantor.

The notes (Cusip: 17324CEX0) priced on Feb. 23.

The fee is 3.35%.

© 2015 Prospect News.
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