Citigroup's range accrual tied to Russell 2000 show little appeal due to call, buysiders say

By Emma Trincal

New York, Nov. 26 - Citigroup Funding Inc.'s callable barrier range accrual notes due December 2022 linked to the Russell 2000 index offer insufficient reward to investors for the risks incurred, according to financial advisers. The most controversial feature, according to those sources, is the early redemption provision after two years, which, they said is likely to play against investors' best outcome.

The notes will accrue interest at an annualized rate of 8.25% for each day that the index closes at or above 70% of its initial level, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly.

The payout at maturity will be par unless the index finishes below the 50% barrier level, in which case investors will share fully in losses.

The notes will be callable at par on any interest payment date beginning in December 2014.

"I'll pass on this one," said Carl Kunhardt, wealth advisor at Quest Capital Management, who said that the notes will be called if the market is favorable to the investor because the option to redeem early is at the sole discretion of the issuer, unlike an "autocall."

"I have no idea what I'm getting. If it's good, I'm not getting it for more than two years. I don't see it as a very good deal," he said.

If it's good, it's called

According to the prospectus, the issuer is "more likely" to call the notes if the index is above the 70% threshold, which is the positive outcome enabling investors to accrue interest. Moreover, the prospectus stipulated that the early redemption would also be "more likely" if the interest paid on the notes was greater than what Citigroup would pay for a comparable debt security.

"Let me say that in English," said Kunhardt: "If you're making as much money or more money than what we would have to pay you on a corporate bond, we're going to take it away from you. Keep in mind that what you own is unsecured debt though, not a corporate bond. It doesn't have the same protection as corporate debt. The only people behind you are the common stockholders."

Unlike corporate debt, he also noted, investors in this structured note do not receive fixed interest payments and have no guarantee of principal at maturity.

Risks

"There is not a lot of upside. At best you would get 8.25% for two years. If the market goes well enough, that's all you're going to get. It will get called in a heartbeat. The call is not necessarily a bad thing. I just don't like notes where the benefits overwhelmingly accrue to the issuer. If there is some sharing of the risks there's got to be some sharing of the rewards," he said.

"Your interest payments for lack of a better term is your only upside. The barrier, if breached, gives you a one to one on the downside. I see this as a safe play for the issuer, not for the investor who is subject to several important risks."

Among the key risks, Kunhardt mentioned downside risk, reinvestment risk and liquidity risk.

Investors may lose their entire principal at maturity because the downside protection ceases to exist if the index depreciates by 50% or more. While the barrier may seem deep, any breach would trigger stiff losses that can wipe out the entire investment, he said.

At the same time, the upside is capped at the maximum interest rate of 8.25% a year, which investors are unlikely to get in full, he said.

Investors if the notes were called would also be subject to reinvestment risk, he noted. They may be forced to reinvest in a lower interest rate environment or with less attractive instruments, according to the prospectus.

Finally, liquidity risk over a 10-year period if the notes are not called can be a concern too, especially if returns are limited. In addition, credit risk increases as time elapses.

"It's a hit and miss whether you can find somebody to buy the notes," he said.

"Unless you can find a secondary market, there is liquidity risk. Is there a secondary market? Yes. Does the issuer buy back the notes? Yes. Unless you have a definite yes on those two questions, you have to assume you're getting an investment in an illiquid market. That's what all offering documents tell you. I view all structured notes as illiquid investments.

"In this case, if things are good, it's a very short-term note. If things are going bad, you are stuck for 10 years."

Two happy years

Scott Cramer, president of Cramer & Rauchegger, Inc., agreed that investors were at a disadvantage because their potential upside was limited compared to the risk they were taking on the downside.

The call feature represented an additional negative aspect of the structure as it created even more asymmetry in the risk-reward profile, he said.

"I don't like this," Cramer said.

"If you want to get the upside that you want, you'll get called.

"If the Russell gets too volatile, you'll get stuck with it.

"While the 8.25% return sounds good, you can breach that 70% threshold and get only a portion of it.

It sounds good until you start looking at the details. It looks like this greatest steak on earth but in reality, it's overdone and it's small."

Investors can lose more than they can get, he said.

"It's 8.25% for every day the index is above 70%. So it can easily be less than 8.25% and it's not going to be more. Meanwhile, you're taking full downside risk. That's asymmetrical," he said.

In addition, the variable duration of the product makes the investment even less attractive to investors.

"You have two years of upside and 10 years of potential downside. It's not even close to being symmetrical," he said.

"I don't think the two years upside is worth taking the chance of being stuck for 10 years.

"The only way you keep this is if the Russell is down. It's like a put. Then they can put it on you for 10 years.

"The person who would take this would be someone who is not bullish, someone who simply believes that the Russell is not going to drop by more than 30% for two years. If that's what you believe, then it's a good thing for you.

"But if the index does really good, you know you're not going to get it for 10 years because they'll call it.

"I don't think it's a good deal," he said.

Citigroup Global Markets Inc. is the agent.

The notes will settle on Thursday.

The Cusip number is 1730T0ZR3.

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