Citigroup's autocallable notes tied to Amazon do not beat covered call strategy, adviser says

By Emma Trincal

New York, Feb. 13 - Citigroup Inc.'s autocallable contingent coupon equity-linked securities due Sept. 4, 2014 linked to Amazon.com, Inc. shares are an alternative to a covered call but with less appeal, said Kirk Chisholm, principal and wealth manager at NUA Advisors.

"With the notes, you're not certain of getting your interest payment. When you write a covered call, you get your income up front in the form of a premium," he said.

The notes will pay an annualized coupon of 7% to 9% each quarter only if the closing price of Amazon.com shares is equal to or greater than the downside threshold price, 80% of the initial share price. Otherwise, holders will not receive the contingent interest payment for that quarter, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be automatically called at par plus the contingent coupon if the closing price of the underlying shares on any of the first five quarterly valuation dates is greater than or equal to the initial share price.

If the notes are not automatically called, the payout at maturity will be par plus the contingent coupon if the final share price is greater than or equal to the downside threshold price. If the final share price is less than the downside threshold price, investors will receive a number of shares equal to the principal amount of notes divided by the initial share price or the cash value of those shares.

"It's a covered call minus some of the benefits of a covered call," Chisholm said.

When writing a covered call, an investor owns the shares of the stock while selling a call on the security, betting that the price will not rise above the strike. If it does, the investor will not participate in the gain above the strike.

"With a covered call, you get cash up front. The premium is your income and you get it no matter what. You own the stock and you're writing a call out of it," he said.

Covered call

Chisholm considered as an example an initial price for Amazon of $260 per share.

"As of now, I could buy Amazon for $260 per share," he said.

"If I sold a January 2014 call at a $260 strike, I could get approximately $30.50 in premium."

The trade would generate an 11.75% return for the length of the contract, which is 11 months, he said.

A contract commands a hundred shares of stock.

The 11.75% return would be equivalent to a 12.8% annualized return, he said.

"I'm only mimicking the notes with an at-the-money call sold at the $260 strike because it's when the stock is above the initial price that you're going to get called away," he said.

"With the notes, I have a lower coupon of 7% to 9% a year. The notes are also longer in duration - 18 months versus my less-than-one-year trade.

"But most importantly, they're only paying you on the quarters where the stock is above the 80% strike. In this case, the stock has to trade above $208 for you to get the coupon. They're not guaranteeing you to get paid.

"In other words, there is a big gap in yield between the notes and the option strategy. You're talking almost six percentage points more for the call writer. And with the notes, you're not even guaranteed to even get that premium, while the option trade is giving you 12.8% on day one. Call writing offers you a higher yield, a guaranteed one and a shorter duration."

Upside risk

Scott Cramer, president of Cramer & Rauchegger, Inc., agreed that the coupon, even if paid, was not adequately compensating the investor.

"Clearly, they're trying to find ways to give income to people because the market is just tough. But this doesn't excite me," he said.

"You're only getting a 7% to 9% return. The problem is on the upside. If it goes up, they're going to call it.

"And if it's below 80%, you can lose everything. There's so much more downside than there is upside potential here.

"The only circumstances where the notes would make sense would be if somebody believed that the stock would stay between 80 and 100. The chances of that happening with a stock like Amazon don't seem to be very good.

"It's easier to lose money than it is to make money with this one."

Carl Kunhardt, wealth adviser at Quest Capital Management, said the notes were too risky.

"It's not a good risk/return. Think of what Amazon is. Amazon is a retailer and a tech company. Even though it's a retailer, it has seen its margins compressed by all those brick-and-mortar retailers that have started their own online businesses. And you now have Google who is trying to do the same thing with Google +," he said.

Tough sale

Regardless of the potential return of the product, Kunhardt said that he was not interested in the product due to its complexity.

"Lately we're seeing too many products that are not straightforward, I would say unnecessarily complicated," he said.

"Think about how investors feel about the industry in general. No matter how much your client trusts you, making it complex doesn't help.

"I'm not sure why they're creating those products with conditional coupons and soft barriers and bells and whistles that make clients uncomfortable."

In addition, not having a fixed coupon made the deal all the more difficult to sell in his view.

"Maybe it's the [firms'] hedging strategy and they have to go to contingent. Maybe it's the complexity of the options," Kunhardt said.

"But those guys at those firms are smart. They have to figure out different ways to build a better mousetrap. Making these notes complex doesn't make a good mousetrap."

The notes (Cusip: 1730T0RV3) are expected to price Feb. 27 and settle three business days later.

Citigroup Global Markets Inc. is the underwriter.

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