Citigroup’s notes on Fidelity multifactor yield index 5% to premiere new rules-based index

By Emma Trincal

New York, Feb. 8 – Citigroup Global Markets Holdings Inc.’s 0% notes due Feb. 28, 2028 linked to the Fidelity Multifactor Yield index 5% ER introduces in a structured note this underlying index launched in December 2019, according to data compiled by Prospect News.

No other notes registered with the Securities and Exchange Commission have used this underlying before, the data showed.

The Fidelity multifactor yield index 5% ER index seeks to maximize risk-adjusted dividend yield while targeting a 5% volatility, according to Fidelity Product Services LLC, the index sponsor. The rules-based index allocates between 10-year Treasuries and cash to account for potential changes in interest rates, then adjusts allocation of the equity component daily with a goal to meet a 5% volatility target.

The payout of the notes at maturity will be par plus at least 100% of any index gain, according to a 424B2 filing with the Securities and Exchange Commission. The exact participation rate will be determined at pricing.

If the index falls, the payout will be par.

Value protection

Kirk Chisholm, wealth manager and principal at Innovative Advisory Group, said that notes offering full principal protection against market declines are welcome at this stage of the longest bull market in history.

“The index reduces the volatility of the portfolio by cutting the equity exposure when volatility increases. If the market sells off, that’s exactly what you want. You want to be protected. So, having 100% of principal-protection is certainly a good thing,” he said.

“We are in a bubble. It doesn’t mean the market can’t continue to go up for some time. Maybe we have another two years left in this bull market.”

Opportunity cost

A shorter duration would have been preferable, he said, even though it is very difficult to price total protection on shorter-dated notes given how low interest rates are at this time.

“In seven years, we will already have seen a recession,” he said.

The length of time of the notes is “potentially problematic” because investors may miss some of the high returns accompanying a recovery after a recession, he noted.

“Worst-case scenario with the note, you get your money back. But it could also lower your return potential. The downside here is the opportunity cost.”

Portfolio structure

The risk section of the prospectus warned that the main risk of the index was indeed low returns because of the volatility control feature of the index, which will increase exposure to cash and Treasuries when the volatility rises. As a result, the index is likely to “significantly underperform” during an equity bull market, according to the prospectus.

The index allocates automatically between equity, the 10-year treasury and cash with daily rebalancing.

The equity and fixed income combined have to show a realized volatility below 5%; otherwise, more has to be allocated to cash.

In addition, the weight for respective equity and fixed income has to be in inverse proportion to their respective realized volatilities. If the equity bucket is four times more volatile than the fixed income bucket for instance, then 80% of the portfolio will go to fixed income and only 20% to equity.

Simple note, tough index

“Part of this is going to be complex for clients to understand. At the same time, products like this one address some of the issues investors face toward the tail end of a bull market,” said Chisholm.

Carl Kunhardt, wealth adviser at Quest Capital Management, saw little benefit in the notes.

“It would take at least 10 minutes to explain this index to a client and probably more if the client is an inexperienced investor. Right there, it’s a problem,” he said.

Allocation

Another issue was the place of the note in a portfolio.

“It will never be part of a core portfolio. It’s part of the supplemental allocation, something that we call the satellite,” Kunhardt said.

He explained that his core allocation usually is about 90% of the portfolio, which includes 50% equity and 40% in bonds. The remaining 10%, or “satellite” is designed to implement tactical plays.

“We may put energy or health care tactically in our satellite. But I’m not sure the note would fit in there.”

Delayed payout

The real “value-add” of the note, he said, was the principal-protection. But even that was not enough.

“Your principal is guaranteed, but seven years is a long time. At the end, you may end up with nothing,” he said.

“Can’t you do better with a real income product, something that pays a fixed rate every six month and that you can easily explain to a client?” he said.

“I think so.”

As of Jan. 31, the annualized return of the index was 2.71%, according to Fidelity.

While CDs pay usually less than 1% for five or seven years and a 10-year Treasury yields less than 1%, a traditional fixed-income investment would still be preferable for this adviser.

“A CD may not yield as much, but it’s a guaranteed coupon with no credit risk up to a certain amount. It’s not something tied to a complicated index which may yield zero return after seven years,” he said.

“With a CD you get paid semiannually. It’s real income.”

Ordinary income

Another negative associated with the note was its tax treatment common to all principal-protected notes with a 95% or 100% guarantee.

“You have to wait seven years to get paid assuming you get any return. In the meantime, you’re getting hit with ordinary income taxes, which is terrible. Each year you pay taxes on a phantom income that you haven’t even earned. Clients hate it,” he said.

For investors seeking equity exposure with less volatility, Kunhardt said that low volatility exchange-traded funds offer an alternative.

“They play the low volatility game pretty well. They’re totally out of favor right now, but they do offer attractive risk-adjusted returns,” he said.

Citigroup Global Markets Holdings Inc. is the agent.

The notes will price on Feb. 23 and settle on Feb. 26.

The Cusip number is 17328YPU2.

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