Citigroup's floaters linked to Dow Jones - UBS Commodity are risky, bullish bet on asset class

By Emma Trincal

New York, Nov. 18 - Citigroup Funding Inc.'s $28 million of notes due Dec. 22, 2011 linked to the Dow Jones - UBS Commodity Index Total Return are designed for investors with a bullish outlook on commodities, but the downside risk remains great and may be a drawback for some, according to buyside sources.

The notes are designed for growth investors rather than income seekers, sources said. The coupon is equal to Libor and payable at maturity, according to a 424B2 filing with the Securities and Exchange Commission. Libor is currently 0.28%.

The payout at maturity will be par plus triple the sum of the index return minus the Treasury bill amount minus a fee of 0.33% per year. The Treasury bill amount is the hypothetical interest accrued on 13-week U.S. Treasury bills from the pricing date through the final valuation date. The Treasury bill yield is currently 0.25%.

"It's an interesting note. It's a bullish call on commodities," said Steve Doucette, financial adviser at Proctor Financial. "If your view is bullish, the payout offers a great way to leverage your upside."

Doucette examined the relationship between Libor and the Treasury bill amount. The interest payment increases with the Libor rate while the payout decreases when the Treasury yield rises.

"Your coupon based on Libor is very correlated to the T-bill. So you end up paying just the fee as any increase of the T-bill yield is offset by the coupon."

However, he said that the T-bill is "more volatile than Libor, so you end up paying extra for the volatility and the risk of interest rates going up."

No buffer

The structure does not provide for a downside protection mechanism, according to the prospectus, which Doucette said is a concern as "we typically look for buffers."

The notes are putable if requested by all holders, and they will be called if the index closes at or below 85% of its initial level. The payout will be calculated in the same way as at maturity, according to the filing.

"I'm not sure I'm comfortable with this call provision, and I would have to look at it more closely before making an investment decision," said Doucette.

"I'm bullish on commodities long-term, but I would have to see if I'm also bullish short-term. That's the hard part," he said.

Downside leverage

One of the reasons investors in the notes need to be bullish on commodities is that they have to believe that the underlying benchmark will not decline by more than 15% over the course of one year even though the asset class is volatile, explained Michael Kalscheur, financial consultant at Castle Wealth Advisor.

"If the market is down 15%, I'm down 45%. I don't call that downside protection," he said.

"The way we look at structured products is very specific, very limited. The number-one reason we use it is to reduce risk. If we can't reduce risk, we won't even consider it."

Kalscheur said that if investors wanted to obtain leverage, which is, in his view, what the notes are designed to do, cheaper and less risky alternatives exist.

"You can go out and buy [exchange-traded funds] instead and do exactly the same thing. You don't have to pay extra for a structured product that has limited liquidity and counterparty risk.

"If Deutsche Bank or Wells Fargo came to me, I'm not too worried. But Citi is a huge firm that almost went bankrupt two years ago.

"I'm sure there is a place for this product in some portfolio. They sold $28 million of it. Obviously somebody thinks it's a good idea or a good fit for them.

"But I'd be extremely hesitant to get into something with that much risk as our clients are conservative investors.

"We use structured products to reduce risk. This product is not designed to do that. It is designed to lever up."

Citigroup Global Markets Inc. is the underwriter.

The notes will settle Monday.

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