Citi's $2.14 million contingent digital notes tied to S&P offer cash alternative, short tenor

By Emma Trincal

New York, Dec. 21 - Citigroup Funding Inc.'s $2.14 million of fixed-to-contingent coupon notes due Dec. 24, 2013 linked to the S&P 500 index caught the attention of some market participants for their short maturity and full principal protection as well as for the income opportunity they give investors.

The coupon will be 1.5% for the first year, payable on Dec. 24, 2012, according to a 424B2 filing with the Securities and Exchange Commission.

A contingent coupon of 7% will be paid at maturity if the S&P 500 finishes at or above 105% of the initial level. Otherwise, holders will not receive the contingent interest payment.

The payout at maturity will be par.

'Nice story'

"Some firms are being creative in finding ways to generate some sort of yield for their clients," a sellsider said.

He explained that in the worse-case scenario - short of a default - investors would only get 1.5% for the two-year term, or 75 basis points per year. If the equity benchmark were to gain at least 5% at the end of the two years, investors would pocket the 1.5% fixed coupon plus the 7% contingent coupon, a total 8.5% return on the trade, or a 4.25% annualized return.

"This is offered as an alternative to cash," the sellsider said. "Compare it to the two-year Treasury yielding 25 basis points.

"It tells you a nice story. If the market performs well, you get a bonus coupon of 7% based on the S&P being up only 5% plus a fixed. If it's not, you get three times the Treasury [yield]."

For this sellsider, the short maturity was the most unusual aspect of the structure.

"It fills a gap ... [in] the demand for short-dated full principal protection notes. You don't see that many in this segment of the market," he said.

The average maturity for principal-protected notes is eight years, according to data compiled by Prospect News.

Small size

The small size of the deal surprised this sellsider.

"Maybe they only did two million because it was the first time they were showing it," he said.

"Or perhaps it's because those types of deals are not necessarily so easy to sell.

"Sometimes I have issues with those types of products. Are clients really shooting for the S&P? Or are they buying it for income? It's got to be clear from a marketing standpoint."

Still, the structure was seen as attractive even if the deal was not for everyone.

"I am surprised they didn't do more of this. It's got an attractive initial coupon plus the contingent coupon," a fixed-income trader said.

"But we wouldn't have a lot of success selling this. Our clients are much more comfortable with the FDIC protection as opposed to taking the credit risk of the bank.

"We've just had an awful lot of volatility, and our clients like the idea of getting a fixed coupon."

Not compelling

A market participant said that he understood why Citigroup sold only $2.14 million of the notes.

"I don't find it too compelling. It's not a bad trade, but it's not very motivating," he said.

"First, it's not a CD. You're taking on Citi's credit risk.

"Second, if you compare the 1.5% fixed coupon with a Citi plain vanilla bullet paper, which right now is yielding around 4%, you're losing a lot of coupon.

"It's a conservative, easy trade for somebody who doesn't mind giving up a little bit of coupon for the possibility of getting 8.5%.

"Problem is, I'm taking Citi's credit, and they should be paying me more."

The threshold to receive the contingent interest payment is 105% of the initial index level. While it may not seem like a lot, it's still higher than most digital coupon deals, the market participant said.

"The strike is not zero. It has to go up 5% above it before you can earn the digital coupon. It's not very appealing," he said.

"They would have made it much more attractive if they had structured it as a partially principal-at-risk with a strike at 95 instead of 105. By trying to give you full principal protection, they lowered the digital coupon quite a bit. With a 95 strike, they could have offered nearly twice that, something like 12% or 14% easily."

Citigroup Global Markets Inc. was the underwriter.

The fees were 1%.

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