Citigroup’s autocalls on U.S. indexes, EM ETF may offer right entry price if pullback persists

By Emma Trincal

New York, Sept. 20 – Citigroup Global Markets Holdings Inc. plans to price 0% autocallable securities due Sept. 24, 2026 tied to the Nasdaq-100 index, the Russell 2000 index and the iShares MSCI Emerging Markets ETF on Tuesday, a day after the first meaningful equity market sell-off since February.

The notes will be called at par plus a premium of 8.4% per year if each asset closes at or above its initial level on any annual valuation date, according to a 424B2 filing with the Securities and Exchange Commission.

If the notes are not called and the worst performing asset closes at or above its initial value, the payout at maturity will be 42%.

If the worst performing asset falls but finishes at or above its 60% barrier level, the payout at maturity will be par. Otherwise, investors will be exposed to losses of the worst performing asset from its initial level.

On Monday, the iShares MSCI Emerging Markets ETF, the Russell 2000 index and the Nasdaq-100 index dropped 2.7%, 2.5% and 2.2%, respectively. The markets were rattled on fears of Chinese property development company Evergrande facing default with the risk of a global credit squeeze.

The Dow Jones industrial average declined 614 points.

“It’s always good to buy on the dip, even when you have a buy-and-hold objective,” said Carl Kunhardt, wealth adviser at Quest Capital Management.

“That doesn’t mean I would buy these notes.

“I see a lot more speculation than investing, which is not my sandbox.”

Yield enhancer

Jerry Verseput, president of Veripax Wealth Management, said he is familiar with the structure of the notes often called “snowballs” or “step-up.” Those autocallable notes have the particularity of paying a cumulative premium upon the call. But unlike contingent coupon autocall, the call trigger is set at a higher hurdle – the initial level rather than at a lower barrier level.

“I kind of like those step-ups,” said Verseput.

“The return forecasts for U.S. equity over the next decade are so low... GMO has even come up with a negative forecast for the next seven years. If I can get an 8% with my principal protected down to 60% to the original price, I’ll take it.”

In its latest seven-year asset class forecast, research firm GMO predicts real annual rates of return over the next seven years of minus 8% and minus 8.5% for U.S. large-cap and U.S. small-cap, respectively. GMO assumes U.S. inflation will mean revert to long-term inflation of 2.2% over 15 years.

More than par, buffer

“Of course, correlations between the three are low, but they’re still positive. If the correlations were higher, you’d have less return,” Verseput said.

“I use those step-ups all the time. But I tend to do them with a buffer instead of a barrier. I also want to get paid if the underlying is negative but above the downside threshold.”

These structural changes would lead to a lower coupon, he conceded.

“But it’s OK because my goal is not to maximize the return. My goal is to sway the odds that the client will get paid with the maximum potential protection,” he said.

Overall, Verseput liked the structure of the note but would like it even more with the buffer and the call premium paid above the protection threshold.

Correlations

Not getting paid at maturity in the event of a negative performance above the barrier was Kunhardt’s main criticism about the structure. Another one was the higher threshold for the payout.

“All three have to be up and I get different correlations. I can’t imagine emerging markets having a strong correlation with U.S. markets.

The coefficients of correlation between the ETF and the Russell 2000 and between the ETF and the Nasdaq-100 are 0.7.

“I’m not confident all three will be up. It’s one thing for three indices to be above a 70% barrier; it’s another to be above initial price,” he said.

“Keep in mind this is a snapshot. They could all have been up all year then drop in a week, the week when the observation happens. They could uncouple, one going down while the others are up.

“You then have to sit on your hands for the next year. That’s a big opportunity cost.”

To decide whether they should buy the notes, investors have to weigh in costs and benefits.

“Does your need to get this premium exceeds the opportunity cost of sitting on your hands for at least a year? That’s the variable,” he said.

Buy and hold

Kunhardt did not like the length of the notes either.

“The five-year term is too long for me. Even though I use notes with a buy-and-hold approach, I prefer to keep it shorter,” he said.

“The barrier is generous. The premium is reasonable.

“But it’s probably not a note I would consider.”

If the sell-off persisted on Tuesday, investors would get a better entry price. But this would not be a sufficient reason to buy.

“When you buy equities directly, you have the luxury of time. But notes, like options, are based on a defined timeframe.

“Buying at a lower price is good. But it doesn’t mean it’s not risky.

“Only one index has to be down, and you lose one year.

“I don’t have the luxury to wait while the opportunity cost keeps piling up,” he said.

When the likelihood of an automatic call is high, the tenor doesn’t really matter, this adviser said.

“You know your duration is likely to be short. But it’s not the case here. Three uncorrelated indices have to be up and the observation is only once a year,” he said.

The benefit of the memory feature (cumulative premium) was not enough of an incentive either.

“You miss the call. The next year you miss the call again. You can always hope to get called the following year so you can catch up with what you missed before. But people don’t pay for hope.

“I would pass,” he said.

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will settle on Sept. 24.

The Cusip number is 17329QQK9.

© 2015 Prospect News.
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