Citigroup's trigger notes linked to two funds are positioned on lower end of risk spectrum

By Emma Trincal

New York, Aug. 16 - Citigroup Inc.'s 0% trigger return optimization securities due Aug. 31, 2016 linked to a basket of two funds offer moderate return, but the risk is limited too, making the return score of the product - or the measure of its risk-adjusted return - in line with the average of its peers, said Suzi Hampson, structured products analyst at Future Value Consultants.

The basket consists of the iShares MSCI EAFE index fund with a 70% weight and the iShares MSCI Emerging Markets index fund with a 30% weight, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par of $10 plus 1.5 times any gain in the basket, up to a maximum return of 31% to 38%. The exact cap will be set at pricing.

If the basket finishes at or above the trigger level - 75% of the initial level - but below the initial level, the payout will be par.

If the basket finishes below the trigger level, investors will be fully exposed to the decline.

Non-U.S. exposure

"Three years is a little bit longer than most of these leveraged return [notes] that we rate. Generally, it's more like one or two years," she said.

"The underlying is a basket limited to two funds, with one - the developed countries equity fund - carrying a 70% weighting while the emerging market ETF is only 30%.

"You're getting a worldwide exposure to the equity markets at the exclusion of the U.S. and Canada.

"Maybe this is for investors who already have a big portion of their holdings invested in U.S. equity and want to diversify their exposure to international markets. However, besides investing ex-U.S., this type of exposure is pretty broad. Investors are not likely to use the notes to gain access to illiquid assets or to hard-to-reach asset classes, which is sometimes the reason why people use structured products. Rather, the rationale of those notes would be to get a particular risk return profile because constructing a product with this kind of payoff would be quite expensive if you had to do it on your own."

The notes fit into the "leveraged return" category. Future Value Consultants compares each product with products of the same structure type when assigning scores.

Barrier

"This deal gives you a high level of protection, and the gearing is there to help you outperform the underlying," she said.

"It is a perfect example of what a structured product can be used for - increasing the return up to 131% to 138% while decreasing the risk with the use of this barrier.

"The barrier is final, which is always better. And the 25% level is quite decent for protection.

"These products have been popular for a long time; they are well-known, and it's easy to see why they would be attractive.

"You get a similar payoff than with the direct fund but with a tweak, as they are less risky."

The issuer gave a 31% to 38% range for the cap. In its methodology, Future Value Consultants uses a hypothetical level at 25% over the mid-point, which would be 36.25% with this product, or about 36%, she explained.

"Investors have a 12% a year return potential, which is not too restrictive," she said.

"This is one of those leverage notes targeted to the more bullish investor as you get a lower gear but a higher cap. Products with more leverage and a lower cap would be a better fit for the mildly bullish type of investor."

Less market risk

The riskmap is Future Value Consultants' measure of the risk associated with a product on a scale of zero to 10, with 10 the highest level of risk possible.

The riskmap is the sum of two risk components: market risk and credit risk.

"This is a longer-term product, so the credit risk is slightly higher than average," she said.

The credit riskmap is 0.87 versus an average 0.64 credit riskmap for the same product type.

Citigroup's credit default swap spreads on a five-year term are "pretty much" in line with other firms at around 105 basis points, she said.

Morgan Stanley shows CDS spreads of 140 bps. But Bank of America and JPMorgan have spreads of 112 bps and 83 bps, respectively, she noted.

"The creditworthiness is not the conclusive factor here. The main reason for the higher credit risk in this particular product is really the duration," she said

On the other hand, the market risk - as measured by the market riskmap - is "quite a bit lower" for this product, at 2.11, compared to the average of the same product type of 2.78.

"It could be the nature of the protection," she said.

"A lot of times, these products would have a buffer of maybe 10% or no protection at all. The 75% final barrier seems a bit more attractive.

"In addition, you sometimes get more volatile underlying assets. You could have single stocks -although it's less common - or other funds or indexes that are more volatile. Finally, having a basket instead of one security or index as your underlying will reduce the overall volatility, especially given the fact that the more volatile of the two, the emerging markets fund, represents only 30% of the basket. If the notes were tied to the emerging markets fund alone, the volatility would be much higher."

The implied volatility for the EAFE fund and the emerging markets fund are 15% and 21%, respectively. In comparison, the S&P 500 has a volatility of 13%.

"These two funds show a higher volatility level than the S&P, but not hugely higher," she said.

As a result of the slightly higher credit risk and lower market risk, the notes have a riskmap of 2.97, which is "much less" than the average for the same product type of 3.42, she said.

Average return score

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets 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 scenario would be bullish, she said.

The product presented no difference from its peers on the risk-adjusted return metrics.

Its return score of 7.69 was only slightly higher than the average for the same product type of 7.61.

"We can't really say it's better. The score is more average," she said.

"We know this product has a lower risk than the majority of products in this structure type. So the fact that the return score is average indicates that the return they're offering is in line with other products available in the market given the risk.

"Since we have here a less risky product but one that has an average return score, we can conclude that the return paid by the issuer is most likely lower than other products. But that's what you get for picking a lower risk product.

"With a product at the lower end of the risk scale, investors forgo some of the higher return they may get with riskier products."

Price, overall scores

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10.

This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes show a 7.47 price score against 7.75 for the average of the same product type.

"It's a bit lower than average, but it's not bad. It's subject to change given that we have a cap range, so it may go up or down depending on where the cap settles," she said.

Future Value Consultants offers its opinion on the quality of a deal with its overall score. The score is simply the average of the price score and the return score.

The notes received an overall score of 7.58 versus 7.68 for the same product type category. The average for all products is 6.78.

"These leveraged products are popular. They've been around for a long time. A lot of investors are comfortable with them. They priced quite competitively," she said.

"So while this product shows a slightly lower overall score than its peers, you can still be happy with that. First because the difference is very small, and second because we're dealing with a product type that has an average overall score much higher than all other products."

The notes (Cusip: 173095159) are expected to price Aug. 27.

Citigroup Global Markets Inc. is the agent, and UBS Financial Services Inc. is the dealer.

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