Citigroup's fixed-to-float notes tied to Russell 2000 are floaters with equity risk exposure

By Emma Trincal

New York, July 23 - Citigroup Inc.'s upcoming fixed-to-float equity-linked securities due Aug. 5, 2020 linked to the Russell 2000 index have an unusual structure, a structurer said, characterized by the fixed-to-floating coupon and the exposure of principal to equity risk. The result is a hybrid between fixed-to-floating-rate fixed-income products and trigger notes, he added.

"I haven't seen that type of structure - where you have a fixed-to-floater coupon and some equity exposure - except for reverse convertibles. But the reverse convertible is too different to compare. It's a short-dated product, usually one year, and it's linked to a stock. Most importantly, it's only a fixed coupon," this structurer said.

The interest rate is expected to be a fixed rate of at least 4.05% for the first three years. Beginning Aug. 5, 2016, the interest rate will be Libor plus 315 basis points. Interest will be payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

If the final index level is greater than or equal to the trigger level, the payout at maturity will be par. The trigger level will be 65% of the initial index level, according to the prospectus.

If the final index level is less than the trigger level, investors will lose 1% for every 1% that the final index level is less than the initial level.

The current Libor is 26 basis points. With the 315 bps spread, the floating rate, if set today, would be 3.41%.

"There are lots of structures with a fixed-income look-alike profile that give you equity risk with a deep barrier. This one is quite different though," the structurer said.

"The fixed-to-floater coupon combined with the risk of losing principal based on the index is rather unique."

For this structurer, the floater rate was designed to add appeal to the product.

"The variable component is a play for people who believe interest rates may go up. Or it's a copy of the fixed-to-floaters type of notes, a very popular structure in fixed income," he said.

"Typically in fixed income, you have the principal protection but you also have the callability feature. Here they get rid of the call feature. In exchange, you get the equity exposure."

Hybrid

He noted that the seven-year tenor was shorter than most fixed-income notes.

"Those notes were probably designed to compete with longer-dated fixed-income deals," he said.

"If you look at Fixed-Income Land, what do you have? Basically two things: the pure fixed-income note and the trigger note. This one is somewhat in between."

He described the "pure fixed-income note" as a principal-protected product with a longer-dated maturity and usually a call feature.

The trigger note, he said, is also a longer-dated product with a seven- to 15-year maturity. Another common feature is the callability. But the trigger note was different in several ways, according to this structurer.

"First, the trigger note is not principal-protected. You have downside risk below a barrier. It's usually a deep barrier, but you still have the equity exposure that you don't have with the traditional fixed-income instrument," he said.

"Second, your coupon is contingent upon the index being above a trigger. Therefore it's more risky, which is why it pays more. You're typically getting contingent coupons in the 6% to 8% range."

Riskier than a trigger note

In comparison, the Citigroup fixed-to-floating product was a "hybrid", he said.

"Here, you don't have the callable feature, so in some sense it's better for the client. Also, the coupon is not contingent but guaranteed. It's not subject to equity moves," he said.

"In essence, these notes are more conservative. Compared to the trigger note, the coupon is a little bit less even if it switches to floater later on. That's because the coupon is not subject to the index moves.

"But in exchange it's not callable, which is a plus for many investors because when your note gets called, you stop receiving your coupon. It terminates your investment, while with this one, you keep getting the coupon.

"It's probably more conservative than the trigger note but a little riskier than the traditional fixed-income note."

Asked if he thought the structure had the potential to gain traction, he said that "it's not clear."

"They're probably trying to breach the gap between fixed-income investment and equity investment.

"The problem is that I don't know if the economics are compelling enough.

"This note is a little bit in between two extremes without giving clearly the advantages that each side of the market is looking for, which is safety for the conservative investor and yield for the less risk-averse investor. You have 4%, not 6% to 8%, and you can still lose your principal.

"The fixed-income market is a large market. How much market share can you win by having this type of hybrid that doesn't give you the best of both worlds?

"I'm not sure it will necessarily be exciting enough for people to go for it," he said.

Inflation hedge

Dean Zayed, chief executive of Brookstone Capital Management, was intrigued by the hedging benefits of the product.

"I like the overall structure very much because it does give you a hedge against rising rates and potential inflation over the next seven years," Zayed said.

"We almost have to assume that Libor will rise over the next seven years. I like the floater and the structure of the notes because if rates go up, you get rewarded for that.

"You have the higher-interest-rate hedge built into the structure that would complement another product. I could see this as a complementary note which you would add to a core note that would pay you more."

While other investments exist to hedge inflation, this product had a particular appeal, he noted.

"Not all inflation hedges are equal. You have to believe that Libor will be somewhat correlated to the important market-movers - the Fed, the stopping of QE, inflation. It's pretty transparent. In comparison, other hedges like gold for instance are not as correlated to these significant triggers," he said.

"That's the right idea. I like the terms. I'm not sure how competitive it is though. You're taking on risks and you get rewarded for it. I'm not certain that you get rewarded enough.

"The structure is good. I like it. I just would love to see higher coupons."

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price July 31 and settle Aug. 5.

The Cusip number is 1730T0UL1.

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