Citigroup's Index Lasers tied to Russell 2000 offer less risky option than direct equity play

By Emma Trincal

New York, Jan. 9 - Citigroup Funding Inc.'s 0% Index Leading Stockmarket Return Securities due January 2014 linked to the Russell 2000 index offer an attractive alternative to a direct investment in the index, sources said.

They noted that the contingent downside protection does not cause investors to give up a lot of potential upside, making the product competitive compared to a direct equity investment in the benchmark.

High cap

"For somebody who wants to invest directly in the Russell and is willing to give up some upside potential for a lot of downside protection, this is a good investment," said Scott Cramer, president of Cramer & Rauchegger, Inc.

If the index finishes above the downside threshold level - 70% of the initial level - the payout at maturity will be par plus the greater of the upside payment and the index return, subject to a maximum return of 50%, according to a 424B2 filing with the Securities and Exchange Commission.

The upside payment is expected to be 16% to 20% and will be set at pricing.

If the index finishes at or below the downside threshold level, the payout will be par plus the index return with exposure to losses.

Risk mitigation

"It's a good trade-off in my opinion," said Cramer.

"Without a doubt, the Russell is more volatile than a large-cap index such as the S&P 500, but for the upside you're giving up, everything above 50%, you're still getting a generous amount of downside protection," he said.

Cramer said that the notes could be used to mitigate risk because of the minimum positive return offered when the 70% barrier is not breached. Even a significant negative performance of the small-cap benchmark could translate into gains, he noted. The digital payout makes the risk/reward profile of the product appealing for those seeking exposure to the small capitalization segment of the U.S. equity market, he added.

"You could still get a 16% to 20% return at maturity even if the market goes down 29%. That's a generous payout," he said.

"This would definitely serve a purpose for the risk asset portion of a client's portfolio. You would mitigate that risk and have a better protection than a direct investment in the index," he said.

The payout at maturity is subject to the credit risk of Citigroup, however, which brings some risk to the notes compared to an investment in the benchmark.

"It's not risk-free, obviously, since you're subject to Citigroup's credit risk. But hopefully they won't go out of business in the next two years," Cramer said.

Early fruits

For some, the underlying asset class is what makes the investment opportune in this phase of the economic cycle.

Carl Kunhardt, wealth adviser at Quest Capital Management, said that he liked the notes based on his bullish outlook.

"It's a pretty plain vanilla note. It will very much depend on your outlook coming out of an economic downturn. If you believe that over the next two years, the economy is going to recover, then that would be a good investment," he said.

The investment could pay off as small-cap stocks usually appreciate earlier than large caps in the recovery cycle, he said.

"If you're building a car, you can't build it until you build the engine, and you can't build the engine until you build the starter. It's the small companies that build the starters, not GM. You're going to see a recovery in the small companies first because they feed the large companies," he added.

Bullish outlook

"I think the bet on the Russell is a good bet simply because we're already in a fairly good recovery," Kunhardt said.

"Of course, if you're very bearish on the market, the small caps are going to lead you into the downturn.

"That note is going to be driven by your outlook on the economy."

Kunhardt said that he is bullish because an important factor affecting market uncertainty will be removed at the end of the year.

"The market can adjust to pretty much anything except uncertainty. Once we pass the elections, regardless of which side wins, we're going to know what the rules are going to be. It will be a plus for the market," he said.

In addition, the payout structure makes the product compelling, he said.

"It's point-to-point, and that's good. I can see the index breaching the 30% at some point within two years. But I just can't see it finishing down 30%," he said.

The securities (Cusip: 1730T0QZ5) are expected to price on Jan. 26.

Citigroup Global Markets Inc. is the underwriter.

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