Citigroup’s $10.89 million bearish barrier notes on S&P 500 stack the odds in investors’ favor

By Emma Trincal

New York, July 29 – Citigroup Global Markets Holdings Inc.’s $10.89 million of 0% bearish barrier market-linked notes with daily barrier observation and conditional return for barrier event due July 26, 2023 linked to the S&P 500 index give investors a fair chance to hedge and monetize a market pullback with relatively limited risk, advisers said.

A barrier event will occur if the closing level of the index is less than the lower barrier, 80% of initial level, on any day during the life of the notes, according to a 424B2 filing with the Securities and Exchange Commission.

If a barrier event occurs, the payout at maturity will be par plus 10%.

If a barrier event does not occur and the final level of the index is greater than or equal to its initial level, the payout at maturity will be par. Otherwise, the payout will be par plus the absolute value of the index return.

Barrier event

“This is a very interesting note. I think the odds are in favor for investors,” said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

He explained why while describing the three possible payouts based on three different scenarios.

In the first one, the barrier event occurs, and investors get their 10% return at maturity regardless of where the index closes at maturity. Kaplan said such situation was by far the most likely to happen while still offering a good return.

“This is a pretty good note because you have a good chance of getting 10%. Ten percent in one year is very attractive,” he said.

Absolute return

The second scenario with the potential absolute return may offer a positive return greater than 10% and up to 20%.

But Kaplan considered this scenario improbable.

“Unless the index drops a small amount – and I don’t expect that it will, I don’t think investors should hope to get the absolute return anywhere near 20%. I don’t even think you’re likely to get 13% of 14%. There’s a very low probability for this to happen. At some point you’re going to get triggered,” he said.

He was referring to the barrier event.

“The odds of getting 18% or even 13% without ever going down more than 20% on any trading day are very small.

“We are in a bear market and bigger drops are coming up this year.”

“90% of the time you’re going to end up below 20% at some point. That’s just the way the market fluctuates,” he said.

No matter how bearish investors may be, the margin of error was large enough, he said.

“Just because you’re unlikely to get 15% or 20% in one year doesn’t mean it’s a bad note. In fact, it’s an excellent note because you have a very high chance of getting your 10%. That’s a good deal,” he said.

Bullish scenario

Finally, in the third scenario, in which the S&P 500 index finishes flat or up, investors get their money back at maturity. This too implies that the barrier event never occurred.

Such setup allows investors to be wrong in their bearish bet.

Since investors are not getting anything more than their principal, this scenario can be considered the worst of the three.

But Kaplan again minimized the odds for such outcome as he predicted at least a 20% decline at some point during the 12-month period.

“People don’t understand that we’re in a bear market. They think it’s over,” he said.

“A number of analysts or pundits proclaim that the market has bottomed, that we’re at the early stage of a bull market or that the inflation problem is going to be fixed...here is what you should be buying now...whatever they say, you can make your own bullish stories. People are just not prepared for a big drop,” he said.

“That’s another reason why the note is interesting. It goes against the herd mentality.”

From that perspective, Kaplan said that the most likely scenario is the barrier event yielding a 10% return for the year.

“I think it’s a really good note,” he said.

Under the hood

Kaplan said he was curious to know how the issuer had been able to price the notes given the favorable risk-return profile for investors.

“I think they were able to do this because volatility is very cheap. The VIX is at its lowest since April. The price of put options has dropped to amazingly low levels. Why? I’m not sure. I think it’s because no one can imagine that the market can drop 20% from where we are.

“The Bogleheads dominate the conversation. They encourage people to buy stocks just at the wrong time,” he said.

Regardless of how the note had been hedged and priced, Kaplan said he liked it.

“It’s something I may actually consider investing in,” he said.

Notes vs. inverse ETF

Donald McCoy, financial adviser with Planners Financial Services, pointed to the advantages offered by the product in comparison with a typical inverse ETF.

“It’s a tempting note for bearish people because you’re not overly penalized if you’re wrong,” he said.

Unlike an inverse ETF, which generates a loss when the market is up, the notes at least offered full principal protection, he added.

“In case the market goes down more than 20% at any point, you’ve locked in 10%. So, if it happens and the market is up by any percentage point, you have your 10%. Your risk would be unlimited with a bearish ETF.”

Mildly bearish

An inverse ETF would outperform the notes if the index happened to finish below the 20% strike, he noted.

“If it’s down 25%, the note gives you 10% while the inverse ETF returns 25%. So, in that case, the notes would underperform the ETF,” he said.

This is why the notes would be more appropriate for moderately bearish investors, he said.

“A very bearish investor would probably go for a 3x inverse ETF, which personally I would never touch with a 10-foot pole,” he said.

The notes reduced the risk associated with betting against the market.

“It makes sense for investors who want to have some downside protection but don’t necessarily think the world is ending. Worst case, you still get 10%,” he said.

Good hedge

McCoy also believed that the chances of benefiting from the absolute return payout were slim.

“If the market is really bearish or trending down, it’s going to break through the barrier at some point; so, I don’t think you should count on this absolute return. You’d have to be pretty lucky to finish down after one year without busting through the 20% barrier at any time. It would be an odd scenario just because of the volatility,” he said.

In conclusion, McCoy said the notes may provide an attractive hedge.

“It’s a better instrument than your typical inverse ETF in many ways. If you’re bearish, you’re not negating any of your gains on the long side if the market is up.

“If you’re wrong, if the market is up, you’re flat.

“It’s a good hedge,” he said.

Citigroup Inc. guarantees the notes.

Citigroup Global Markets Inc. and UBS Financial Services Inc. are the agents.

The notes settled on Wednesday.

The Cusip number is 17330PRG6.

The fee is 1%.

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