Citi opens week with $25 million of principal protected notes linked to best two of three currency baskets

By Kenneth Lim

April 28 - Citigroup Funding Inc. led the week's new products with $25 million of principal protected notes linked to the best two of three currency baskets.

The product offers investors a relatively safe way to hedge against the dollar, but returns run the risk of underperformance, an investment adviser said.

Citigroup priced the zero-coupon notes due April 29, 2010 linked to the best of three currency baskets at par of $1,000 each.

At maturity, the notes will return par plus the arithmetic average of the two best basket returns among the three baskets if the average is positive. If the average is negative or zero, investors will receive par.

The first basket comprises equal weights of the value of the Chinese yuan, the Indian rupee, the Philippine peso and the Singapore dollar relative to the dollar. The second basket comprises equal weights of the value of the Brazilian real, the Canadian dollar, the Mexican peso, the Norwegian krone and the Russian ruble versus the dollar. The final basket is made up of equal weights of the value of the Czech koruna, the Polish zloty and the Turkish lira relative to the dollar.

Citi notes offer hedge

The notes appeal to a growing number of investors looking to hedge against declines in the dollar, said a California-based investment adviser.

"The falling dollar has definitely been on the minds of many investors," said the adviser, who did not purchase any of the notes. "When the dollar is weaker, the value of your U.S. dollar-denominated investments is obviously also weaker, so what you want to do is figure out how to work around that. We have looked at global funds, emerging market funds, commodities, currencies."

The Citigroup product appears to be an unusual but relatively safe way of diversifying through currencies, the adviser said.

"A number of things about this are striking," the adviser said. "First of all, it's linked to the best two out of three, so that means even if one of the baskets doesn't do well, or actually even if two of them are negative, all you need is for one or two of them to do well enough and then you'll get a positive return. What this does is it takes away some of the risk that you might get if it was linked to just one basket or some of those worst-of products."

The division of the currencies into three baskets was unusual, the adviser said.

"I think it's interesting how they split the currencies," the adviser said. "Well, except for one or two of those currencies it's mostly emerging markets. The first one is basically an Asia play. If Asia continues to do much better than the U.S., that basket should continue to improve. The second basket is probably oil and energy, and the last one is quite interesting, it looks like emerging Europe."

"I'm not a currency specialist, so maybe there are unique aspects of those currencies that I don't recognize, but that's how I think the currencies were divided," the adviser said. "So that's one way of thinking about where each of those baskets are heading."

Risk of underperformance

The principal protection feature probably attracted investors, but the bigger risk in the product is underperformance, the adviser said.

"It's principal protected, so you don't have to worry so much about getting your principal back at maturity," the adviser added. "I think you'd be more worried about not getting enough out of this."

The mechanics of the payout structure suggest that the eventual return on the product is unlikely to be very high compared with other possible investments, the adviser said.

"At the end of it you'll be averaging the return on the two best baskets, so there's a good chance you'll underperform quite a number of those currencies," the adviser said. "I don't think it means much that the returns aren't capped because for currencies the changes might not be big enough. It's definitely better than just taking an index of all the currencies, because this one lets you discard those that don't do well, but I can't help thinking that surely there are other products out there that will give you a better return...You could have outperformance notes, you could have leveraged notes, I think there are some structures that could give you potentially better upside."

The adviser said the low potential gains could be a consequence of the principal protection.

"Maybe they were trying to target investors who were maybe new to currencies, so they offered a relatively low-risk kind of product," the adviser said. "But as an investor you have to understand that there's a cost to having a certain level of peace of mind, and generally that cost comes out of your upside."

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