Citigroup's 0% notes linked to S&P 500 offer full protection, but trade-off is lower return

By Emma Trincal

New York, Jan. 31 - Citigroup Inc.'s 0% market-linked notes due Aug. 29, 2019 linked to the S&P 500 index deliver full principal protection against a market downturn over a relatively short duration but the trade-off for investors is to accept the possibility of underperforming the underlying index, said Suzi Hampson, structured products analyst at Future Value Consultants.

"The issuer accomplished that by giving investors a participation rate of less than 100% and by introducing an averaging feature for the calculation of the final index value," she said.

If the average index return percentage is greater than zero, the payout at maturity will be par plus 90% to 100% of the average index return percentage. The exact upside participation rate will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

If the average index return percentage is less than or equal to zero, the payout will be par.

Averaging

The average index return percentage will be the average of the index's return on each of the quarterly valuation dates, which are expected to be the 25th day of each February, May, August and November during the term of the notes. The return on each valuation date will be measured relative to the index's closing level on the pricing date.

"The averaging makes the cost of the options cheaper, which allows the issuer to introduce better terms. In this case, the improvement compared to most similar structures is the relatively shorter maturity. Most principal-protected notes mature in seven to 10 years," she said.

"The averaging feature smoothens out the volatility. Especially if you're averaging out throughout the life of the product, it will reduce the volatility even more, which will potentially lower your return. Because volatility is lower, the cost of buying the options will be less, since you're getting a lower premium for a return that's potentially not as high as the index itself.

"Think about it that way: If you have a point-to-point observation, there is a wide range of outcomes. If you're measuring it every day, the volatility will flatten. The more observation points and the longer the period of time, the bigger the effect. We have quarterly, not daily, observation points here, but it goes on for a long period of time."

Less participation

The other aspect of the structure that lowers the return is the participation rate, which could be less than 100% and even as low as 90%, she said.

"You're getting 100% of your principal back and your participation in the return. The participation rate is stated in a range between 90% and 100%. We apply the same methodology used with coupons in a range. We pick the hypothetical value at 25% below the higher end," she said.

The hypothetical participation rate would be 97.5% in this case, which is the value Future Value Consultants has used to run its model, score the notes and generate its report. If the issuer were to price the notes closer to 90% than 100%, the impact on the scores would be negative, she said.

Along with averaging the index performance, the lower participation rate lessens the potential gain.

"If it's 90% instead of 100%, you end up giving up not just the dividends but some of the return. Obviously, you're going to be underperforming the growth of the index," she said.

Investors could get less growth than the index if the index does not move up much until the end or even if it goes down and then surges back up toward maturity, according to the prospectus.

The prospectus illustrated how the combination of the averaging feature and the less-than-100% participation rate could significantly cut investors' gains.

The prospectus included a hypothetical example in which the index has a point-to-point positive return of 13% and an average return of 6.5%. With a participation rate of 90%, investors would only gain 5.85% (the average index return multiplied by the participation rate) rather than getting a 13% return. Overall, the investor in the notes would underperform the index by about 7%.

"You are clearly limiting your upside in exchange for the capital protection," she said.

"This is obviously for a conservative investor who is willing to give up the total potential return because his main focus is capital preservation.

"But as with all structured products, this investor should be aware that he is still exposed to credit risk.

"Losing some of the potential upside also allows the investor to get the principal protection on a relatively shorter basis than most equivalent products, which typically have seven- to 10-year maturities. For a principal-protected note in the U.S., this one is on the short end of the range."

There were 193 fully principal-protected notes issued last year with an average tenor of eight years, according to data compiled by Prospect News. Those products, all market-linked notes, do not include fixed-to-floating-rate notes linked to Constant Maturity Swap spreads or range accruals.

Credit risk

A look at the credit risk is another way to confirm that the product is shorter than its peers, she noted.

Future Value Consultants measures the credit risk with its credit riskmap, one of the two components of risk along with market risk.

The sum of the market riskmap and credit riskmap constitutes the riskmap, which is Future Value Consultants' measure of risk on a scale of zero to 10.

The notes have a credit riskmap of 1 versus an average of 1.14 for principal-protected products.

The market riskmap of 0.43 is much lower than 1.40, the average for the product type, she noted. Adding those two components, the 1.43 riskmap of the product is much less than the 2.53 average for the category.

The product shows a lower level of market risk when compared with other principal-protected notes simply because the score is calculated by comparing returns with the risk-free rate, she explained.

In the case of the notes, the likelihood of "beating" the return of cash and Treasuries is greater than with similar notes even though investors are less likely to score higher returns, she explained.

Trade-off

"Investors in this note are exchanging a portion of the returns for the capital protection. There has to be a trade-off. When you get full principal protection, you're unlikely to get a higher return than the underlying. It makes sense," she said.

"Other trade-offs would include having a cap. In order to get the full 100% return, you would have had to extend the maturity beyond the five-and-a-half-year term. This issuer decided to keep it shorter, but in order to put the structure together, they had to limit some of the upside.

"For someone who needs principal protection, the trade-off here is shorter duration and protection against lower return.

"Of course, such product is not going to be an easy sale. For most investors, getting 100% of the index is more appealing than getting less given that you're already giving up the dividends. The protection has a price, and in this case, the price is underperforming the index. It's not for everyone. But you have investors who are wary of a seven- to 10-year note, and for those, not getting a one-to-one upside exposure is an acceptable compromise."

Future Value Consultants measures the risk-adjusted return with its return score. The rating is calculated using five key market assumptions: neutral assumption, bull and bear markets and high- and low-volatility environments.

The return score is 8.37 versus an 8.20 average score for products of the same type.

"It's slightly better than similar products, and if you're an adviser, it's OK to recommend it if it's above average. But it doesn't mean you should rush into it. The score is just an indication that you're getting good returns based on the risk," she said.

Price score

For each product, Future Value Consultants computes a price score that measures the value to the investor on a scale of zero to 10. This rating estimates the fees taken per annum. The higher the score, the lower the fees and the greater the value offered to the investor.

The notes have a 9.92 price score, compared with 9.44 for the average principal-protected note.

"This is a score that's even significantly higher," she said.

"The options are quite transparent, and the structure is relatively simple to put together, that's one factor.

"It also reflects the hypothetical participation rate we picked by convention, which is close to the higher end of the range. It will remain a very good score if the participation rate remains at the end of the range. But if it drops more toward 90%, the impact on the score could be quite negative. The participation rate is the most important factor, the one that definitely will impact the final price score the most.

"We're at 9.92. You can't do much better than that. In fact, I can't recall ever seeing 10."

Overall score

Finally, the overall score measures Future Value Consultants' general opinion on the quality of a deal. The score is simply the average of the price score and the return score.

The overall score of 9.14 exceeds the average for this product type, which is 8.82.

"It's an impressive score. The top price score is what's making it higher than average," she said.

"There is nothing in this product that could be perceived as a red flag or could put people off.

"As an investor or an adviser, you're getting a note with an above-average score. It's quite different than most principal-protected products, but it's relatively simple to understand. You get a five-and-a-half-year investment linked to the S&P 500 with full principal protection. It's quite appealing. You just have to be ready not to perform as well as the benchmark if the market is up."

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price Feb. 25.

The Cusip number is 1730T0H36.

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