Citigroup's annual observation coupon notes tied to S&P 500 may not compensate enough for risk

By Emma Trincal

New York, Nov. 1 - Citigroup Funding Inc.'s annual observation coupon notes due November 2016 linked to the S&P 500 index provide an above-average annualized coupon, but 80% of the principal remains at risk, which for some sources represents an inadequate risk versus return trade-off.

Interest will be payable annually, according to a 424B2 filing with the Securities and Exchange Commission.

If the annual index return is greater than zero, the coupon will be 6.5% to 7.5%. The exact percentage will be set at pricing. If the annual index return is zero or negative, the coupon will be 3%. The annual index return will be measured from the prior annual observation date, which occurs in November of each year.

If the final index level is at least 80% of the initial index level, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% that the index declines beyond 20%.

Assuming that the maximum interest paid is 7%, the most investors may receive in income after five years would be 35%, according to the prospectus.

The least of their potential upside - should they only get the 3% minimum each year - would be 15%.

Limited upside

"If you collect a string of 3% coupons, you effectively accumulate 15%, so with the buffer, you have to lose 35% before you start to lose money," noted Frederick Wright, partner and chief investment officer at Smith & Howard Wealth Management.

"I like the downside protection of that."

However, Wright said that too little upside is offered.

"I'm not as crazy about the upside," he said. "If they could give you more, I may be interested."

He suggested several structural changes that could make the product more appealing based on his own risk tolerance.

One of them would be to compare the index level each year to the initial level instead of its level a year earlier.

"It would be much better if they gave you the 7% based on a comparison of the index with the initial date, not with what the performance was the year before," he said.

"Or maybe they could offer more than 7% as a maximum rate while still keeping the same minimum rate.

"I just don't like not having any participation in the upside beyond 7%. What if the market is up 50%?

"Perhaps a way to address that would be to give the investor a higher rate of return if the index hits a certain threshold on the upside. For instance if the market is up 50%, you get half of that - it's just an example. I'd like some sort of guaranteed participation if the index jumps to a certain level."

Not enough protection

Mike Sherzan, president and chief executive officer at Bankers Financial Services LLC, also noted that the protection exceeds the simple buffer amount.

"You get at least 35% of your principal back with the minimum coupon and the buffer," he said.

But for Sherzan, who structures mostly market-linked certificates of deposit, the notes do not provide enough protection against risk.

"I wouldn't be interested. I only go into those [structured notes] for the principal protection," he said.

"What if you have another 2008 with the market down 40%? I'm not comfortable with it.

"I would rather suffer a degradation of interest for principal protection.

"For the risk averse or fixed-income investor, you're better off with a step-up or some laddering than taking the risk of this instrument."

Analysis

A market participant said that the notes are "interesting" but that investors have to compare them with what is comparable.

"You have to take into account the credit risk of Citigroup," he said.

"I guess my question would be 'Where's the five-year plain-vanilla Citigroup trading at?' It's 3½%. So at 3%, you're losing some coupon. They're actually paying less than that.

"On the other hand, you get twice the potential upside on the [3½%] coupon.

"If I were an investor, that's how I would break it down: Compared to the plain-vanilla five-year Citi paper, I'm getting a little bit less in coupon but I can also get twice the coupon."

Another way to evaluate the product, he said, would be to compare it with another five-year structured note linked to the S&P 500 that would feature the same 20% buffer.

"In a credit-neutral environment, what type of cap do you get on a five-year note with a 20% buffer? If it's a 20% cap, spread that over five years and see how it compares," he said.

The notes (Cusip: 1730T0PU7) are expected to price on Nov. 28.

Citigroup Global Markets Inc. is the underwriter.

© 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.