Citigroup's leveraged notes due 2016 linked to S&P 500 index offer rare mix of buffer, no cap

By Emma Trincal

New York, Sept. 30 - Citigroup Inc.'s offering of 0% geared buffer securities due Oct. 5, 2016 linked to the S&P 500 index is an unusually attractive deal, sources said, as it offers upside leverage with no cap along with a buffer on the downside.

The downside leverage factor and the three-year tenor are seen as minor compromises to get what sources said is an unusually appealing payoff, one that is geared toward both risk-averse and growth-oriented investors.

If the final index level is greater than the initial level, the payout at maturity will be par plus 119.75% of the index return, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index declines by up to 10% and will lose 1.1111% for every 1% that it declines beyond 10%.

No cap

"If I had to design something, this would be really close to what I would want," said Michael Kalscheur, financial adviser with Castle Wealth Advisors.

"It's an attractive little note. It's a very transparent, baseline index, a good issuer, no issue on the credit side," said Carl Kunhardt, wealth adviser at Quest Capital Management.

"There is more leverage on the upside than on the downside. They're giving you the buffer. That's good. And you're not capped on the upside. The fee is not out of the ballpark."

The underwriting fee is 50 basis points, according to the prospectus. The estimated value of the notes will be between $975.00 and $986.20 per $1,000 principal amount.

Leveraged notes with no cap typically do not offer buffers, said Kunhardt.

"They'll give you a barrier or nothing. It's very rare to see the full upside and some element of protection. You don't see that anymore," he said.

"Sure, it's not a one-year or a two-year. But a three-year is kind of standard. Very few notes are totally uncapped while still giving you a buffer. In order to get that, you would have to go much longer, just like you have to go even longer for the full principal protection. In fact, you don't see principal protection anymore, or if you do, you have to go seven-year or longer."

Kunhardt said that he recently saw a three-year note linked to the Euro Stoxx 50.

"It had a 10% buffer, but it also had a cap," he said.

"I would consider this Citi note for some of my aggressive portfolios or even some less aggressive types of clients.

"But I don't have this product available. Raymond James doesn't offer it. They don't show aggressive structured notes. I get a lot of principal-protected, buffered notes, but you don't tend to see much of anything with leverage ever.

Quest Capital Management is a registered investment adviser affiliated with Raymond James.

"I would like to see more products like that. On the other hand, I don't know if it would make a difference because I only have a handful of clients who would do more aggressive products like this one," he said.

"Personally though, I find this product totally attractive. It's a very nicely designed product without a lot of complexity."

Uncapped, yet leveraged

The combination of a buffer on the downside and no cap on the upside is not very commonly seen, Kalscheur agreed. But the mix of having no cap but getting leverage on the upside is also very unusual in itself, he noted.

"This is exactly the kind of structure that I would be looking for. Not only do I have the unlimited upside, but I also have the upside leverage. You don't see that as often as you'd like, and you will not see it very often on a three-year," Kalscheur said.

While other aspects of the structure are less appealing - for instance, the downside leverage, the issuer's credit and the maturity - they are minor in comparison to the benefits offered by the issuer, he noted.

"It's a Citi, which is not the top-rated credit that I would probably bet on, but it does meet my bare minimum criteria, especially for a three-year note. In three years from now, do I think Citi will still be around? Sure, I do," he said.

"With the lower credit that Citi is dealing with, they have more facility in sweetening the deal. I doubt I could get the same terms with RBC or Wells Fargo."

Kalscheur said that he finds the upside leverage factor satisfactory as a way to offset one of the downsides of investing in structured products, which is missing on the dividends. In the case of the S&P 500, investors give up 2% per year, which is the dividend yield of the benchmark.

"I'm not a two-times leverage, three-times leverage type of guy. I like the 1.2 times in particular because it helps to offset the loss of the dividend in an up market," Kalscheur said.

"If the S&P is up 10% a year for three years, a straight note would have underperformed by 6%, which means you would earn at the end 24% rather than 30%.

"Getting the 1.2 times leverage makes you offset some of that difference."

Geared buffer

Most investors would not consider the geared downside buffer as a "deal breaker," he said.

"I like the 10% buffer. It's not a cliff. It's a hardline buffer. Sure, I'd like 15% or 20%. But I'd much rather have a 10% buffer than a 15% barrier," he said.

"As for the downside gearing, I have yet to find a client who would find it to be a problem. If the index is down 10%, the client is even. If it's down 20%, you're losing 11.11% instead of 10% with a traditional buffer. You're still outperforming the index. I doubt I'm going to have the client complain that they're losing 11.11% instead of 10%," he said.

Kalscheur said that he noticed more downside gearing buffers in recent weeks.

"I'm not sure if it's a trend. I suppose it has to do with pricing. Investors may prefer those types of buffers to a longer maturity or a barrier," he said.

"As people become more comfortable with them, as clients in general become more sophisticated, you'll see more and more of these geared buffers."

When looking for structured notes for his clients, Kalscheur said that he wants ideally to see no cap and a buffer.

"It's quite rare to get both. I have a very distinct goal in mind for structured products when I search products for my clients. I am looking at mitigating the downside risk while giving them the potential to get decent returns. It weeds out 90% to 95% of everything I see."

He said that he recently saw a three-and-a-half-year product tied to the S&P 500.

"It was uncapped on the upside and had a buffer that could be between 15% and 20%. But you only had one-for-one on the upside," he said.

"When I look at leverage items, they are typically capped," he added.

"This summer, we did see a three-year with a 120% upside participation rate and a 10% buffer and there was no cap. But it was tied to the S&P 500 Low Volatility index, which carries a dividend yield almost a full 1% higher than the S&P. If you're giving up dividends, you're giving up a lot more than a just standard S&P product."

Citigroup Global Markets Inc. is the underwriter.

The notes were expected to price Sept. 30 and settle Oct. 3.

The Cusip number is 1730T0VJ5.

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