Citigroup’s $292,000 notes on basket of two indexes offer protection, but inflation is a risk

By Emma Trincal

New York, March 2 – Citigroup Global Markets Holdings Inc.’s $292,000 of 0% market-linked notes due Aug. 29, 2025 based on an equally weighted basket of the S&P 500 index and the iStoxx Europe Economic Growth Select 50 index provide full principal protection, but the risk of lower returns should not be overlooked, sources said.

The payout at maturity will be par plus the average basket return. If the average basket return is zero or negative, investors will receive par.

The average basket return is the average of the interim basket returns on each of the quarterly valuation dates beginning on May 26. For each valuation date, the interim basket return is measured from the initial basket level to the closing basket level on that valuation date.

Opaque

For Jerrod Dawson, director of investment research at Quest Capital Management, the quarterly averaging is a double-edged sword.

“It’s probably the only way they could provide principal-protection over that timeframe without having to cap your return. So that’s the good part,” he said.

“But the averaging makes it difficult to form an opinion.

“You can have a very different set of results with this calculation and probably lower results.

“The added complexity of quarterly averaging gives me pause.”

Alternative to cap

With interest rates at record-low levels, pricing zero-coupon bonds providing full principal protection is increasingly challenging. Issuers have used a variety of ways to generate what investors are eager to obtain: the removal of market risk exposure in the current market correction.

“It’s an attractive way to protect 100% of the investment without the cap,” said Dawson.

“What makes it problematic for me is that it’s not as transparent as a cap.

“The averaging is a more subtle way of mitigating the volatility.

“But by the same token, it’s going to lower the upside.”

Underperformance possible

The prospectus indeed alluded to this: “The return on the notes may be significantly lower than the actual return on the basket, as measured from the pricing date to the final valuation date, because of the manner in which the average basket return percentage is calculated.”

Another factor, which may dampen returns, derives from the choice of one of the two basket components.

The iStoxx Europe Economic Growth Select 50 index picks stocks with a low volatility and high dividend yields.

Lower volatility may be associated with lower growth potential, according to the prospectus.

To be sure, the index adds a growth factor by assigning a higher weighting to stocks of companies, which the International Monetary Fund projects to have greater GDP growth over the next year.

Still, given the averaging calculation and the choice of low-volatility stocks in the European index, the risk remains that the basket may underperform the broader market, the prospectus warned.

Dividends

Lower returns with full principal-protection can be a reasonable trade-off, said Clemens Kownatzki, independent currency and options trader.

“This looks pretty good to me. Your capital is guaranteed. It doesn’t seem like there’s anything wrong with this deal, just some risks and limitations,” he said.

One of such “limitations” is the non-payment of dividends over a 5.5-year period, he said.

“You’re giving up the very high-dividends paid by the European index,” he said.

The second issue is inflation, although it is very difficult to assess such risk, he added.

“I wish I would know what inflation will be in five years.

“Everybody has been so wrong about inflation and interest rates.

“With all the rate cuts and injection of liquidity in the system we’ve had for years, if somebody had told me that the 30-year yield would be at 1.60% I would have thought they were crazy. So far, the Fed has not increased inflation. It just pushed up asset prices – stocks, bonds, housing prices – with the exception of commodities.”

And yet, this trader believes that inflation risk is real.

“The notion of negative yields as we see them in Europe is against everything I learned in finance. But we seem to be moving in that direction as well,” he said.

“For how long? I still think we’ll have inflation.

“Inflation is very hard metric to predict because it’s so personal.”

For Kownatzki, official data on inflation is not representative of reality.

“For lower-income and middle-class households inflation is not at 2% right now. It’s probably more between 3% and 4%.

“Either the Bureau of Labor Statistic should change the way it calculates CPI or the Fed should measure inflation differently. But they don’t.

“So, if prices are much higher in five years, the return on the notes may not be enough to offset the impact of inflation. I think this is the real risk associated with this product,” he said.

But investors should weigh that risk against the current tumult in the market, which puts portfolios at risk.

“I still like the notes. The market is very volatile right now as a result of the coronavirus.

“You know you can put your money there for some time and not worry about losing principal. You don’t have any limitation on the upside. I kind of like it,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes (Cusip: 17327TA55) priced on Feb. 26.

The fee is 3%.

© 2015 Prospect News.
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