Citigroup to issue notes, CDs tied to Dow Industrials with distinct payout calculation methods

By Emma Trincal

New York, June 2 - Citigroup has announced the pricing of two structured products linked to the Dow Jones Industrial Average, one in a certificates of deposit wrapper, the other in a note format.

The products have nearly identical durations, full principal protection and the same participation rate range. Besides the existence of a coupon for the notes and FDIC insurance for the CDs, the major distinguishing factor is how the payout at maturity is calculated, sources said.

The notes offer a payout based on the average of 11 index return percentages while the number of return percentages being averaged out at maturity is 24 for the CDs.

"In general, the more data-points you have, the more you can level out volatility," said Suzi Hampson, structured products analyst at Future Value Consultants.

Note and CDs

Citigroup Funding Inc. plans to price 0.5% market-linked notes due Dec. 21, 2016 linked to the Dow Jones Industrial Average, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable semiannually.

The payout at maturity will be par plus 100% to 110% of the index return, subject to a minimum payout of par. The exact participation rate will be set at pricing.

The index return will be the average of its returns on June 21 and Dec. 21 of each year from December 2011 through December 2016.

Separately, Citibank, NA plans to price 0% market-linked CDs due June 26, 2017 linked to the Dow Jones Industrial Average, according to a term sheet.

The payout at maturity will be par plus 100% to 110% of the index return. The index return will be the average of the percentage change in the closing value of the index on 24 quarterly valuation dates.

Investors will receive a minimum of par at maturity.

Data-points and volatility

Hampson said that other factors than the number of valuation dates for the payout calculation also matter - for instance, duration.

"Usually what makes a difference is the length of time. But here, five and a half years for the notes and six years for the CDs is not going to be significant," Hampson said.

If the objective is to reduce the ups and downs of the underlying index, the CDs offer a better choice, she said.

"We see it when we compare weekly and daily averaging. The daily averaging is the one that smoothes out volatility the most."

Ultimately though, the investor needs to have a view not just on where the Dow Jones index will be at maturity but what its direction will be during the term, she noted.

"To know what the market will do over a period of five or six years requires having a sophisticated opinion," she said.

"If the market is down for the most part during the term and up at the end, averaging is going to injure performance compared to a point-to-point calculation.

"If the market is up throughout the time and down at the end, averaging on the contrary is going to be advantageous."

Whether based on quarterly or semiannual valuation dates, averaging will do more to reduce volatility than a point-to-point calculation, Hampson said.

"It reduces the cost of the option; it makes pricing cheaper. That's one way to throw in there the principal protection," she said.

Limiting volatility

Matt Medeiros, president and chief executive officer of the Institute for Wealth Management, said that "regardless of the direction of the market, the structure that has the greatest number of valuation dates should smooth volatility the most," which, he added, gives an advantage to investors in the CDs.

In addition, the CDs put investors under less credit risk because of the FDIC insurance, he said.

"The idea behind those two structures is not really to time the market or predict its direction. The main concept is to reduce volatility through averaging.

"The choice depends on the value you place on the number of valuation dates.

"The FDIC insurance also plays a part."

On the other hand, other terms play less of a role in helping investors choose between the two products.

"I would say the coupon paid on the notes is negligible to make a difference. It's not advantageous enough to say it's a better opportunity," he said.

"And the six months [of] difference between the terms of the two notes is not pertinent either."

Medeiros said that based on those criteria, the CDs offer the best value because they give investors both the FDIC insurance and a potentially less volatile return through the more frequent valuation points.

Zero return risk

Steve Doucette, financial adviser at Proctor Financial, said that he did not like the long durations of those products. Investors get their principal back, but there is no guarantee that they will get paid anything on top of it after five or six years, he said.

In addition, he objected to the complexity of the payout calculation method.

"I'm always a fan of simplicity," Doucette said.

"When you have these actuaries coming up with these notes, it blows me away. You have to spend a lot of time figuring out if you're better off with the average of 11 or 24 closing levels.

"Is more better than fewer? Not necessarily. It depends on the trend. If the note is going down and down, you're adding more down. It's like answering the question how often do you rebalance a portfolio? Doing it too often can hurt you too.

"We don't know where those market cycles go over a five-year cycle, and that's the bottom line."

Doucette agreed that the coupon offered in the notes is not a significant factor that would determine which product is the best.

"The CD has the advantage of the insurance. It also has more valuation dates," he said.

"But I like the timing of the valuation dates in the notes - June and December. Go away in May, come back in October. That could be a plus for the investor.

"To me none of these products work because it's too long term. I might like those products a lot with a shorter duration, like two or three years. I wouldn't feel comfortable tying up my money for six years when you know that, based on historical performance, you have a bear market every three and a half or four years," he said.

The notes (Cusip: 17308CRW8) are expected to price June 24. Citigroup Global Markets Inc. is the underwriter.

The CDs (Cusip: 172986DF5) are expected to price June 21.Citigroup Global Markets is the agent, and Advisors Asset Management, Inc. will act as the distributor.

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