Citigroup’s 15-month PLUS linked to Russell 2000 index to outperform in lackluster market

By Emma Trincal

New York, Dec. 1 – Citigroup Inc.’s 0% Performance Leveraged Upside Securities due March 21, 2017 linked to the Russell 2000 index will allow investors to outperform the small-cap U.S. benchmark if the market turns out to be – as many analysts are already anticipating – flat or only slightly up, sources said.

If the index return is positive, the payout at maturity will be par of $10 plus 300% of the index return, subject to a maximum return that is expected to be at least 17.05% and will be set at pricing. Investors will be exposed to losses if the index declines, according to a 424B2 filing with the Securities and Exchange Commission.

Tom Balcom, founder of 1650 Wealth Management, said that the product is a good choice in a slow equity market scenario.

Investors are expecting more volatility and more subdued return next year after a long-running bull market and the prospect of the Federal Reserve hiking rates.

Since 2009, the Russell 2000 has produced double-digit gains each year except for a 4.45% negative performance in 2011 and a 5% gain last year.

Equity replacement

“As a substitute for a long-only position, I like it,” said Balcom.

“Obviously there’s no protection, so if you’re a bear, don’t bother buying it.

“But if the Russell has only a slightly positive return, this gives you the opportunity to outperform.”

While the Street consensus is not yet bearish for next year, many analysts have low expectations, he noted.

“Just look at Goldman Sachs saying that the S&P will finish the year 2016 at 2,100,” he said.

Goldman Sachs issued last week a research note predicting that 2016 will be flat for U.S. stocks. The firm sees a 2,100 valuation for the S&P 500 index at the end of next year.

The index closed at 2,102.63 on Tuesday.

Goldman Sachs strategists argued that rising interest rates and the strengthening of the dollar will be a challenge for U.S. stock investors.

“What they predicted for the S&P is probably true for the Russell 2000 as well. Both benchmarks are pretty correlated,” he said.

Gloomy outlook

The five-year trailing annualized return as of the end of the third quarter is nearly 12% for the Russell 2000 versus 13.5% for the S&P 500, he noted.

“If you think returns are going to be modest, the three-times leverage is a great way of maximizing your performance. If you have exposure to the Russell 2000 via mutual funds or ETFs, it’s a good replacement strategy,” he said.

The 17% cap is the equivalent of a 13.5% maximum return on an annualized compounded basis. In order to achieve those gains, the Russell needs only to grow at a rate of 4.5% a year, he said.

“Your only risk really versus a long-only investment would be if the index was up 20% or more. Not many people think it’s going to happen, but if the index rallies next year, then sure, you will underperform.

“That’s not how the strategists at Goldman Sachs see it though.”

‘Not bad’

Jack Ablin, chief investment officer of BMO Private Bank, offered a similar analysis.

“It’s really a note for investors who don’t expect the Russell 2000 to do much at all next year,” he said.

“It’s not bad. The Russell has a lower yield than the S&P, and it’s a short maturity, so you’re not missing much dividend.”

The dividend yield on the Russell 2000 and the S&P 500 is 1.45% and 2%, respectively.

“For those who already hold the Russell, they can swap their position into that. They would only lose if the index was up by more than 17%,” he said.

Some investors may consider the odds of missing on the upside as a lesser risk when it comes to the Russell 2000 compared to the S&P 500.

“The Russell is a little bit more overvalued compared to the S&P,” he said.

“Also, small caps typically don’t have the same access to capital that large caps do. As liquidity is starting to wind down when the Fed tightens and credit spreads widen, that would tend to disadvantage the Russell related to the S&P 500.

“If the performance of the Russell is mediocre, this note would do well. You just don’t want the Russell to go up very much.”

Citigroup Global Markets Inc. is the underwriter. Morgan Stanley Wealth Management is a dealer.

The notes are expected to price Dec. 16.

The Cusip number is 17323P538.

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