Citigroup's Lasers linked to Russell 2000 have decent terms along with credit risk, long tenor

By Emma Trincal

New York, April 13 - Citigroup Funding Inc.'s 0% Index Leading Stockmarket Return Securities due October 2015 linked to the Russell 2000 index offer an attractive payout structure, but the other side of the coin is a three-and-a-half-year holding period, said Suzi Hampson, structured products analyst at Future Value Consultants.

If the index finishes above the downside threshold level - 80% of the initial level - the payout at maturity will be par plus the greater of the upside payment and the index return, according to a 424B2 filing with the Securities and Exchange Commission.

The upside payment will equal 20% to 25% and will be set at pricing.

Otherwise, the payout will be par plus the index return with exposure to losses.

"Three-and-a-half years is a bit longer than usual for this type of product. But it makes it easier for the issuer to offer better terms," Hampson said.

"The longer tenor increases credit risk significantly. At the same time, it improves the pricing of the protection."

Regardless of whether the index finishes up 19% or down 19%, investors will receive either way a positive return, she said.

Straddle like

"In that way, the structure is similar to a straddle, but it's even better," she said.

A straddle in Future Value Consultants' terminology is a "twin-win" note.

Those products give investors an opportunity to score a gain even if the market declines as long as the decline does not break a certain threshold.

The first advantage of this product over the straddle is that investors get the return enhancement benefit of a digital payment. If the index declines above the buffer, the return jumps to 20% instead of simply tracking the absolute value of the index decline, she explained.

"It's also better because with a straddle, the index price is monitored through the life, whereas you have a point-to-point here," she said.

"And secondly, straddles tend to be capped, while you have with this note an unlimited upside."

Different views

"Obviously, you'd have to compare the terms and see if a straddle may offer a lower barrier and a shorter duration. Maturities make a difference. Since the cap is in absolute terms and not on an annualized basis, a 20% on a three-and-a-half-year is of course going to be quite different from a 20% on a one-year note," she said.

The product would fit two different investment outlooks, she said.

One could reflect the cautiously bullish view: the investor seeks as much growth as possible while being concerned about the downside risk.

"This product will perform best in a bullish scenario since there's no cap," she said.

"But if you're really bullish, you should be able to find better terms either through a shorter duration or with leverage."

The other view would be that of a skeptical investor who would be unsure about the direction of the market. Hampson drew a parallel between this structure and a reverse convertible.

"With both types of products, a low-volatility scenario is best. You just don't want your underlying to move too much one way or the other. You want to earn the fixed return. It doesn't matter if it goes up or down as long as it stays in that 20% range," she said.

"Obviously, the big difference again is the tenor: reverse convertibles are short-dated products.

"There is another difference here: your digital payout does not limit your upside."

Investors who buy twin-win products would follow the same "low volatility" view, she said.

"It's quite non-directional. In fact, you could make just as much in a down market above 80%. This is something that could perform really well in a flat to slightly bearish market," she said.

However, bearish investors should probably not seek the high returns around the barrier level because the risk is very high at that point, she warned.

"If the index falls by 21%, you're down 21%. If it falls by 19% you're up 20%. That's a big jump, and that's a very sensitive point both for the investor and for the bank that has to hedge this," she said.

The three-and-a-half-year term allows the issuer to offer a lower barrier, explained Hampson. At the same time, it increases the credit risk.

"The longer the timeframe, the more things can happen. You get a better barrier. But the duration makes the barrier more likely to be breached," she said.

Risk

These factors explain the relatively high level of risk in this product as measured by riskmap, a Future Value Consultants rating that measures the risk associated with a product on a scale of zero to 10.

These notes, with a 6.50 riskmap, show a higher risk than the average of all products (4.38) and the average of all similar products (4.42).

The riskmap is composed of the market riskmap and the credit riskmap.

For these notes, both the credit riskmap and the market riskmap are higher than average. But the credit riskmap at 1.45 is particularly elevated compared to an average of 0.70 for all products.

Return score

Despite the risk, the product displays an above-average return score. The return score is how Future Value Consultants measures the risk-adjusted return on a scale of zero to 10. The rating is calculated using five key market assumptions: neutral assumption, high- and low-growth environments and high- and low-volatility environments.

A risk-adjusted average return for each assumption set is then calculated. The return score is based on the best of the five scenarios.

In this case, the best assumption is a low-volatility market environment, said Hampson.

The notes have a 7.09 return score, higher than the 6.72 average score for similar products and 6.50 for all products.

"There is a combination of factors explaining this good return score. First, there is no cap. Secondly, even if the index falls, you can still get a positive return. Finally, you have a barrier observed at maturity, which is always better than on a daily basis or through life," she said.

With its probability chart, Future Value Consultants estimates how the product is expected to perform under the five key assumptions. It assigns a probability of return outcome to each of the payoff buckets.

The chart is generated using a Monte Carlo simulation using various parameters such as volatility, dividends and interest rates.

Based on the low-volatility assumption, there is a 64% chance that the product will generate a positive return versus 36% for a loss.

The neutral growth assumption in comparison offers a 59% gain probability versus a 41% chance of a loss.

Disappointing value

The most "disappointing" score for this product is its pricing, said Hampson.

The price score is Future Value Consultants' measure on a scale of zero to 10 of the market value of the underlying components of the product as a percentage of the initial investment. It gives an estimate of the fees taken per annum.

The higher the score, the lower the fees and the greater the value offered to the investor.

This product shows a 3.05 price score, which is much less than 7.44, the average for products of the same structure type.

"It does suggest that with this duration, they could have offered even better terms. It's a bit of a shame because while it's quite high risk, you get compensated for that," she said.

The price score and return score are averaged to obtain the overall score of the product, which represents Future Value Consultants' opinion on the quality of a deal.

Because of the low price score, this note only gets a 5.07 overall score versus a 7.08 average overall score for products of the same type.

"It will be rescored when it comes to [the] pricing date," she said.

"They may put the terms on the top of the range. I wouldn't write it off as this type of product could appeal to some people."

The securities (Cusip: 1730T0WW5) are expected to price April 24.

Citigroup Global Markets Inc. is the underwriter.

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