Citigroup’s buffered notes tied to Consumer Staples ETF would benefit from leverage

By Emma Trincal

New York, March 10 – Citigroup Global Markets Holdings Inc.’s $450,000 of 0% buffer securities due Sept. 10, 2025 linked to the Consumer Staples Select Sector SPDR fund show a structure that may not be adapted to the defensive nature of the underlying fund, said Clemens Kownatzki, finance professor at Pepperdine University.

The payout at maturity will be par plus any ETF gain, up to a maximum return of par plus 44.2%, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines but ends at or above the 20% buffer and will lose 1% for every 1% that the index declines beyond the buffer.

Kownatzki said he did not understand the rationale behind the structure. Having no leverage on a low-volatility underlying asset seemed “odd” to him.

Unbalanced

“What’s the point of having this particular structure given the underlying? Why have a cap on the upside without having some leverage attached to it?” he said.

In his view, the counter-cyclical sector would not be subject to the same heavy losses stocks in other sectors may incur during an economic downturn. The relatively low volatility of consumer staples stocks called for more enhancement on the upside rather than too much emphasis on the protection, he said.

“Everybody has been talking about an impending recession. If all economists agree, you should take the other side of the trade. But let's just assume that we will indeed have a recession even if it's mild. Consumer staples will probably outperform,” he said.

Producing essentials

The constituents of the consumer staples index are traditional companies producing essential goods like foods, beverages, household products and tobacco.

“I wouldn’t call them blue chips because a company like Microsoft is a blue chip. But they’re resilient during recessions. Even during hard times, people still need to eat, drink and buy necessities at the drugstore.

Some of the top holdings in the fund include Procter & Gamble Co., Coca-Cola Co., Philip Morris International Inc., Walmart Inc. and Colgate-Palmolive Co. among 28 others.

Alpha in tough times

“It’s a defensive sector, which is likely to do better than tech or even the market in general if we get into a recession. We’ve already seen this trend last year,” he said.

The Consumer Staples Select Sector ETF posted a slight loss of 0.8% last year. During that time, the SPDR Portfolio S&P 500 Growth ETF dropped 29.41% and the SPDR S&P 500 ETF Trust shed 18.2%.

“Tech stocks were beaten up last year. The less glamorous consumer staples in comparison did quite well,” he said.

To buffer or not

Kownatzki pointed to the counter-cyclical nature of consumer staples stocks as a magnet for investors seeking relative safety. But in a bear market induced by a recession, all sectors tend to sell off. Sometimes the best ones make for the initial outflows.

“I have a mixed view on the 20% buffer,” he said.

“It’s helpful in a sense, especially if the recession is driven by higher rates and more inflation, somewhere between 6% and 8% for instance,” he added.

“In this kind of scenario, even consumer staples companies need financing, whether it be for projects or new investments,” he said.

If rates continue to be higher, companies in this sector may find it too expensive to expand, he said.

“They’ll be forced to borrow and to invest much less, which would dampen their development and therefore their earnings. Despite their resiliency, consumer staples companies could still feel the shock of a recession especially if inflation persists. They may do relatively better than Big Tech, which are even more sensitive to high interest rates. But they may also be caught in a major sell-off.”

Wrong tradeoff

Given the defensive nature of the sector, however, the buffer should perhaps be slightly reduced to improve the upside. Afterall, the most concerning aspect of the structure, he noted, was the absence of leverage and the presence of a cap.

“I’m not sure I understand the rationale behind this investment,” he said.

“Usually, the tradeoff in a growth note is a cap in exchange for leverage. Here, you’re giving up the leverage for a large buffer. And you’re doing it on a defensive, low-volatility sector that has the capacity to withstand a recession.”

Kownatzki did not complain about the size of the cap. Over the 2½-year term, the maximum return is the equivalent of 15.77% per annum on a compounded basis.

“It’s a nice cap. But what if the stock does not move?

“For the buffer, I’m not saying you don’t need one. But I wonder if the 20% size is warranted given the muted volatility,” he said.

On Friday, a day of heightened volatility in the market, the implied volatility of the ETF was 16.77%, well below the SPDR S&P 500 ETF Trust at 22.70%.

Going long

For Kownatzki, taking a long position in the Consumer Staples ETF would be a better alternative.

“People considering the notes seek exposure to this particular sector. So why not buy the ETF outright?

“The expense ratio of the ETF is 0.1%. I get the 2.6% dividend yield. I don’t have a cap on the upside. There is no expiration date, no maturity date. If we have a severe recession, I could hold the ETF far longer,” he said.

Kownatzki said he could not find a good reason to buy the note.

“I really don’t see the point of capping my upside without leveraging my return for a buffer that ends up being expensive,” he said.

Hedging the position

Instead of using a buffered note, he would hedge his long position with options.

“I would buy the ETF. If the market is up, I would consider buying a put on it, which would be relatively inexpensive,” he said.

Kownatzki said he would use the put for protection against “external changes,” such as an escalation of the conflict in Ukraine or an intensification of the tensions between the U.S. and China.

“It’s not so much the price of the ETF that would dictate my decision to buy a protective put. Rather it would be a change in the environment,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes settled on Thursday.

The Cusip number is 17331CZ42.

The fee is 2%.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.