Accelerated notes linked to single stock highly risky but can offer good returns, analyst says

By Kenneth Lim

Boston, Feb. 18 - A planned issue of accelerated notes linked to the common stock of ArcelorMittal offers potential returns that match the unusually high level of risk, said analyst Suzi Hampson of Future Value Consultants.

Citigroup Funding Inc. plans to price zero-coupon Performance Leveraged Upside Securities due February 2013 linked to ArcelorMittal common stock.

At maturity, investors will receive par of $10 plus five times any gain in the underlying, subject to a maximum total payout of 150% to 155% of the principal. Investors are fully exposed to any decline in the underlying.

The product is quite a bit more risky than most products, Hampson said. Future Value Consultants gave the notes a "riskmap" score of 7.31 out of 10, with 10 being the riskiest. The riskiest recent product received a riskmap score of 8.15.

The expected annualized volatility of the product was 23.87%, according to a Future Value Consultants report, not much better than the stock's 36.03% volatility.

"As far as risk goes, it's the same as buying shares in the stock," Hampson said.

Investors who are comfortable with buying the stock will probably be comfortable with the risk level of the notes, Hampson said.

"If you're talking to financial advisers and if they have an investor who is used to investing in the stock, they shouldn't have a problem explaining this product," Hampson said.

Return compensates risk

But investors also get the potential for a solid return in exchange for taking on that risk.

Future Value Consultants rated the product 9.75 out of a best possible 10 in terms of value, which is the firm's estimate of costs taken out of the product from fees and the profit margin on the underlying derivative. The product got an above-average return rating of 6.71 out of 10 and also earned high marks for transparency with a simplicity score of 8.5 out of 10.

"It's got a high riskmap, which is bad I guess, but it's also got a high value score and a high return score," Hampson said. "Even though this is risky, you are being offered decent compensation in terms of returns."

Investors only need the underlying stock to gain modestly to enjoy the high leverage of 500%, Hampson said. And they will continue to outperform the stock up to a gain of 50% to 55% in the share price. Even if the stock appreciates above the return cap, investors will still enjoy a respectable return even if they underperform the stock.

"If the stock grows by more than 50% in two years, you will lose out on any growth above that level. But because of the gearing up until that point, you will be outperforming the stock," the analyst said.

Because of the high leverage, if investors see any gain from the product, it is more likely to be a significant return, Hampson said. Future Value Consultants estimated that investors had a 54.8% probability of getting more than 15% from the product. On the flip side, investors had a 33.5% chance of losing more than 5% and a 6.9% chance of losing 0% to 5%.

Stock volatility helps terms

Linking the notes to a single stock rather than an index, which is the more common path among accelerated growth notes, helped the issuer to offer better looking headline terms, Hampson added.

"It's mainly indices, and a lot of them are linked to funds, which are easy to put the products together," she said. "We see some single stocks, and the advantage is stocks are more volatile than indices, so you can get better terms for them."

The volatility of the U.S. stock market has been falling, so a similar product linked to the S&P 500 index, for example, would be less risky but would probably not advertise a five-times participation rate with a high return cap, Hampson said.

"When the S&P 500 was very volatile, you could get very good terms on that, and there was less need to look for riskier assets," she said. "But now there might be investors looking for better returns."

The product manages to balance a generous compensation with high risks and wrap it all up in an easy-to-understand package, Hampson said.

"Structured products don't always need to be low risk," she said. "Just as long as the investor understands the payoff and the decent return can only be gained by taking the risk."

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