Citi’s 12% contingent income autocalls tied to three tech stocks show balanced risk strategy

By Emma Trincal

New York, July 20 – Citigroup Global Markets Holdings Inc.’s contingent income autocallable securities due July 30, 2021 linked to the worst performing of the common stocks of Amazon.com Inc., Alphabet, Inc. and Netflix, Inc. present significant risks based on the worst-of payout and the choice of high beta stocks. But the automatic call feature goes a long way to mitigate the risk by increasing the odds of getting paid, said Almudena Rojas, structured products analyst at Future Value Consultants.

The notes will pay a contingent monthly coupon at an annual rate of 12% if each underlying stock closes at or above the 55% downside threshold on the determination date for that month, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus the contingent coupon if each stock closes at or above its initial level on any valuation date other than the final date.

The payout at maturity will be par unless any stock finishes below its 55% downside threshold, in which case investors will lose 1% for each 1% decline of the worst performing stock.

FANG members

“This product is appealing for the depth of the barrier. Obviously, the 12% return is also very attractive,” said Rojas.

However, the reward is commensurate with the risk. The structure is a worst-of tied to three stocks, not two. In addition, the three “FANG” names, which are among the best-performing U.S. stocks, are also highly volatile.

The “FANG” acronym stands for “Facebook,” “Amazon,” “Netflix” and “Google,” now Alphabet.

Fast money

“A lot of the risk is offset by the high likelihood to kick out early,” she said.

The high volatility of the stocks increases the chances of an automatic call, she explained. The Monte Carlo simulation model of the firms showed a very high probability for this to happen in the first year.

“People buying this product want income. They expect a high and immediate return. They should be prepared to hold the notes for a very short time, most likely three months,” she said.

The frequency of the call observation dates is also a reason behind the high likelihood of a call, she noted.

“This note is not designed to last until the end of the three years. It would be a mistake to buy the notes hoping to collect the coupon until maturity.”

Correlation

Reinvestment risk rather than just market risk should probably be high on the list of risks to assess, she suggested.

If volatility, which can push prices up, makes the call event very likely, the high correlation between the three stocks plays a similar role, she said.

That’s because in a worst-of, all underlying stocks need to be at or above their initial price in order to call.

“If one or two are up while the other is down, the product will never kick out,” she said.

“High correlation is a negative when your note is tied to a basket of stocks because you want diversification. It’s the other way around with a worst-of. High correlation means less risk.”

Capital performance tests

Future Value Consultants produces stress testing reports for structured notes. Each report contains 29 tables or tests.

Rojas in her analysis of the Citigroup notes began to look at the capital performance test. This table shows the probability of each of three outcomes: return more than capital, return exactly capital, return less than capital.

A neutral scenario is the basis of the simulation in all reports. It reflects standard pricing based on the risk-free rate, dividends and volatility of the underlying.

The table showed that under such base case, investors have an 80% chance of getting more than capital. The chances of losing money – which means that the notes were never called was 20%.

“The conservative barrier plays an important role in this result,” she said.

The prospect of positive outcomes is strong, she added.

This is due to the combination of volatility and high correlation, which has the potential to propel upward the three stocks in the same direction.

Different markets

The model also explores four hypothetical market scenarios – bull, bear, less volatile and more volatile.

For each market type, the model determines probabilities based on assumptions made for the growth rate and volatility levels used for each underlying.

The same table revealed a 69% probability for the “return more than capital” outcome in the bear market scenario.

Without the autocall this probability would have been lower, she noted.

Even the 69% figure appears high for a bearish environment. This is because Future Value Consultants uses very moderate growth (or negative growth) assumptions when running their model.

Finally, the probability for “return exactly capital” is zero simply because across all scenarios the structure makes it impossible to receive just par.

In order to provide more details on the call, Rojas looked at another table: the “product specific tests.”

For an autocallable product the outcomes are the probabilities of calls at various dates along with the probabilities of receiving the coupon. Coupon payment dates and call dates are both quarterly in this deal.

One-year ticket

Under the neutral scenario, there is a 30.3% chance of a call on the first observation date (call point one), which is after only three months. The probabilities decrease after that, falling to 10.85% on call point two, 6.20% on call point three and 3.94% at the end of the first 12 months.

Overall investors have a more than 51% chance of holding the note for less than a year and to receive either 3%, 6%, 9% or 12% during the holding period depending on when they get called.

Naturally those probabilities vary by scenario. Under the bull assumption for instance the chance of an automatic call during the first year rises to 60%. It falls to 43% in the bear scenario.

Balanced risk

“This is another proof that despite the risks involved with the three stocks, you are very likely to get a positive outcome,” she said.

“This product is designed for people who want to get paid fast and move on into another income-oriented product.

“The autocall reduces the risk significantly. Half of the time, you will be called on the first year. But you won’t obtain the maximum return.”

That’s the tradeoff versus a non-callable note, which would be expensive to price and therefore not as defensive as this one, she concluded.

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on July 27. The Cusip number is 17326K668.

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