Citigroup 1% notes linked to Russell 2000 offer principal protection, shorter term than peers

By Emma Trincal

New York, March 12 - Citigroup Funding Inc.'s 1% market-linked notes linked to the Russell 2000 index offer full principal protection on a shorter duration than their peers, sources said.

The product is designed to also provide investors with income and a chance to participate in the market upside as long as the index does not go above a certain threshold, according to the prospectus.

The maturity date will be between September 2015 and March 2016, according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable semiannually.

If the final index level is greater than the initial index level but less than or equal to the upside knock-out value, the payout at maturity will be par plus the index return. The upside knock-out value will be 125% of the initial index level.

If the final index level is less than or equal to the initial index level or if it is greater than the upside knock-out value, the payout will be par.

"This gives you potential for upside with full principal protection," said Thomas Livingston, director of structured products at Halliday Financial Group.

He said that investors should decide whether the upside threshold is high enough for them based on their own market sentiment so that they may assess the likelihood of a knock-out, which would be a negative event.

"I think 25% in four years is fine. The market has roared from its lows in the past four years. It's unlikely that it will continue to roar in the next four years," he said.

"Of course, if you're extremely bullish, you might say the 25% is not enough.

"You have to give up something. The 25% limit gives you the coupon and the principal protection.

"I think it's a really fair note," he said.

Equity

Scott Cramer, president of Cramer & Rauchegger, Inc., said that investors' ability to earn the return is contingent upon the index closing within a range and not above the upside barrier. This constraint adds risk to the product.

"The Russell is much more volatile than the S&P. On a pure point-to-point, it could be anywhere.

"If you pick 100% long-term point to point with a knock-out, you're playing with fire.

"If at least it had a cap, that would be fine, but this is not a cap," he said.

Income

The product offers a 1% coupon per year, designed to bring an additional benefit to investors. But the coupon amount is not enough to attract traditional yield seekers or even deter cash investors from the benefits of liquidity, said Carl Kunhardt, wealth adviser at Quest Capital Management.

"I could get a better rate on a CD and I would have a better protection with the FDIC insurance. No credit risk," said Kunhardt.

Cramer said that he has seen similar notes that offer a "sweetener" at maturity if the barrier is breached.

"If you get knocked out, they give you at least something so that you're not left empty-handed," Cramer noted.

He said that the notes would have been more attractive with a sweetener or the combination of a sweetener and the 1% coupon.

For Kunhardt, the duration remains too long. Should the knock-out barrier be breached, the investors' return would be limited to the coupon, he said.

"You're getting into an illiquid investment for a little bit more than money market rates. I could get 25% of this in cash but with full liquidity," he said.

"It's not necessarily a bad deal. But I don't really see the point."

Shark bite

The point of this type of security, according to a structurer, is to give investors a fully principal-protected product but with a much shorter duration than the average capital guarantee product, which tends to have a maturity of six or seven years.

"These are [called] shark notes. I've seen them before. What I haven't really seen is a shark note with a coupon," the structurer said.

He explained that a shark note is the equivalent of buying an up-and-out call option that "dies" in some conditions.

"It dies when the price finishes above the knock-out. Then you lose the upside participation," he said.

"And it expires worthless when the final price is below the original price, and that's how you protect your downside.

"In general, I like those shark notes a lot because they allow you to reduce the length of your principal-protected product while giving you some potential upside.

"The trade-off is a shorter duration versus the risk of getting nothing if there's a knock-out."

"Shark notes are great, but I like them on a much shorter duration. Ideally, it should be two years," this structurer said.

In his view, the 1% coupon could be replaced by a higher knock-out making the notes potentially attractive for investors seeking growth.

"The up-and-out call option is very cheap, and it's even cheaper when volatility is high," he said.

"It's ideal to buy when volatility is high because you can push the upside barrier even further.

"To make this product work better, you would have to let go of this coupon. You could use this 1% to buy an option that's further out. An additional 1% would give you a substantially higher upside barrier," he said.

Not for bulls

Jim Delaney, portfolio manager at Market Strategies Management, said that the notes would fit a flat to bearish outlook.

"The index is already up 10% this year. If the Russell is up 6% per year, it's 24%. You get your return. But if it's up an average of 7%, you get nothing. With a one-point difference, you go from 24% to nothing. I don't think the probabilities are in the investor's favor. It's a pretty risky bet if you're a bull. You don't even have to be a raging bull. Even if you're a medium bull, 25% plus in four years is within your reach. You stand a really good chance of getting zero except the coupon.

"It all boils down to the investor's outlook. If you're kind of bearish, it keeps you exposed to the market, gives you a coupon and the principal protection. If you're bearish, you would buy it.

"If you think the market is going to be up and down, you're probably also a buyer of that.

"But if you're medium bullish, this note is not for you.

"I'm pretty bullish. I wouldn't buy that paper," he said.

The notes (Cusip: 1730T0WK1) are expected to price March 26 and settle three business days later.

Sources have used March 2016 as the maturity date, but the actual maturity date will be determined at pricing.

Citigroup Global Markets Inc. is the underwriter.

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