Citigroup's dual directional notes tied to S&P 500 seen as defense for bulls, not bearish bet

By Emma Trincal

New York, Feb. 24 - Citigroup Funding Inc.'s 0% dual directional trigger Performance Leveraged Upside Securities due Feb. 27, 2014 linked to the S&P 500 index seek to outperform the benchmark in a moderately bullish or moderately bearish market, said structured products analyst Suzi Hampson at Future Value Consultants.

However, the notes are more designed for bullish investors than bears given the downside risk, she noted, even if the notes may pay a positive return in a down or up market.

On the upside, the payout is leveraged and capped. If the final level of the index is positive, investors will receive at maturity par plus 150% of the gains subject to a 22% to 27% cap, which will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes offer an appealing payout, Hampson said, as long as the index finishes within a range. On the downside, investors can get a positive return at maturity based on the absolute value of the percentage decline. And on the upside, they can earn up to the cap.

The risk arises when the index closes at maturity below the 80% trigger price.

"At that point, you lose as much as the index. There is no capital protection whatsoever," she said.

Dangerous barrier

Future Value Consultants classifies as "straddles" notes such as this one that offer a return regardless of the direction of the underlying.

While the absolute value return within a range makes those products very appealing, investors should make sure that the notes fit their market view.

"It might appear that you make money in any scenario, but it doesn't really quite work that way," she said.

"It's primarily for the moderately bullish investor because of the cap and gearing.

"Should you be bearish since you can make money if the index is down? Maybe not.

"This note works well if the index is up or down within a range.

"But if it's down, you certainly don't want to breach that 80% barrier. So I would say if you're really bearish, stay away from this product."

"You want the index to move up in order to capture the maximum return. You don't need a lot of growth, but it's still a product mainly aimed at bulls."

Hampson assumed a final cap set at 25.75%, which is situated three-quarters within the 22%-to-27% range and in line with her firm's pricing methodology.

With a 25.75% cap, the index would need to grow by 17.2% in order for investors to maximize their return, she said.

In some cases, investors could earn more on the downside than on the upside, according to the prospectus.

For instance, a final gain of 10% in the index would generate for investors a 15% return. But a 19% decline in the index would translate into a 19% gain since the final price would still be above the trigger.

"Maybe that's one of the problems with these products. It really boils down to how it's going to be sold," she said.

"You don't really want to tell investors it's a win-win: 20% down you're up; 20% up, you're up. That's the danger, because you really don't want to be anywhere near a 20% decline. As an investor, you're better off with an index up 15%. If you hope to score a higher gain by getting closer to the barrier, you have the wrong approach.

"The product is slightly defensive as it enables you to make money when the index is down. But keep in mind you have no downside protection. Once the barrier is breached, you take on all the losses. And a decline of 20% in two years is not implausible. It has happened."

Credit risk

The product shows an average level of risk compared to similar products, or in this case, other straddle notes.

The riskmap for this product is 4.79 versus 4.54 for the average of similar products.

The riskmap is Future Value Consultants' measure of the risk associated with a product on a scale from zero to 10. It is the sum of two risk components: market risk and credit risk.

This product shows a lower market riskmap than the average of all products recently rated by Future Value Consultants. On the other hand, the credit riskmap is higher.

"Your market risk is lower as you compare this with a great number of reverse convertibles that have smaller barriers or are tied to more volatile underlyings, so it's not a surprise," she said.

"The higher credit riskmap probably has to do with duration. The two-year tenor is higher than average. Credit risk is so linked to the length of the product," she said.

Citigroup's credit spreads may also impact the credit riskmap, although Hampson said that the key factor in this case was probably more duration than credit default swap spreads.

Citigroup's CDS spreads were 240 basis points last Monday, she said, adding that "it sits quite in the middle" when compared to other banks such as Morgan Stanley (330 bps) and JPMorgan (120 bps).

Average return

Future Value Consultants measures the risk-adjusted return with its return score. Established on a scale of zero to 10, the return score is calculated under reasonable and consistent forward-looking assumptions.

The firm uses five key assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments. The return score is based on the best of the five scenarios.

The best scenario for this type of structure would be "high growth," she said.

With a 6.55 return score, the product is average compared to its peers (6.67) and all product types (6.44).

"This is pretty normal. For this particular level of risk, you get an average return. It's hard to say how much return you should get here compared to, for instance, a growth product.

"The return score suggests that it's fair in terms of risk/reward."

The return score is derived from the probability of return outcomes calculated by Future Value Consultants using a Monte Carlo simulation and displayed in a chart across different return buckets.

Based on the high-growth assumption, investors have a 55% chance of generating an annualized return of 10% to 15%.

The odds of losing more than 15% of principal are 10.2%.

However, when using the neutral or risk-free assumption, the notes show a less attractive payout outcome with a 35% probability of making 10% to 15% a year and a nearly 20% chance of losing more than 15% of the initial investment.

Price, overall

With its price score, Future Value Consultants rates on a scale of zero to 10 the real value to the investor after deducting on an annual basis the costs the issuer charges in fees and commissions.

The notes have a 4.48 price score, which compares negatively with 6.94, the average price score for this product type.

"It's not very good. It suggests that you're not offering good value for your money," she said.

"There are so many elements in this structure between the barrier, the dual directional payout, the upside, the cap, the gearing. It's hard to pinpoint where you're losing value.

"Sometimes more complex products will cost you more, although I'm not totally sure that it's the case because this note is just a series of fairly simple options.

"It could also be that you don't have that many absolute value products out there, so they don't have to be that competitive. Maybe the terms are easy to sell, so they don't have to price it aggressively. A number of different factors could be at play."

The result, however, is a low overall score of 5.51, well below the 6.81 average overall score for the same product type category.

The overall score is Future Value Consultants' opinion on the quality of a deal. It is the average of the price score and the return score.

The notes (Cusip: 17317U238) are expected to price Tuesday and settle March 2.

Citigroup Global Markets Inc. is the underwriter. Morgan Stanley Smith Barney LLC will handle distribution.

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