Citigroup's $5 million capped notes linked to Euro Stoxx feature eye-catching 5 times leverage

By Emma Trincal

New York, Feb. 20 - Citigroup Inc.'s $5 million of 0% return optimization securities due Feb. 21, 2017 linked to the Euro Stoxx 50 index, despite the small size of the offering, was noteworthy for the product's unusually high leverage along with its generous cap, sources said.

While such structures are not unheard of, they are facilitated by high yielding underlying assets, a structurer noted.

If the index return is positive, the payout at maturity will be par of $10 plus 500% of the index return, subject to a maximum return of 102.8%, according to a 424B2 filing with the Securities and Exchange Commission.

If the index return is negative, investors will be fully exposed to the decline from the initial level.

"It's an investment that allows you to double up your investment in four years," the structure said.

"It's a 25% cap a year, five-times up with a one-for-one downside.

"If the index is up 20%, you're already at 100%, you've already doubled up your investment. It only has to go up 5% a year and you're done.

"It looks like a pretty good deal."

One feature of the structure that may have helped price the high leverage multiple was duration, although it was not the main factor, he said.

"They couldn't have done it in a short-term product. This is a four year. But I think the way they priced it is a direct result of the yield they had at their disposal," he said.

All about yield

The Euro Stoxx 50 index has a 4.5% annualized dividend yield, which is more than twice the yield of the S&P 500, he observed.

Investors in the notes, as it is routinely the case with structured notes, will not receive dividends on the stocks included in the index. The issuer in turn uses the dividends for the pricing of the product.

"When you have a high dividend-yield stock or stock index, it makes the options cheaper to buy. You have Citibank funding; and you're foregoing the dividends. These are key ingredients," he said.

The structurer explained that an investor in the notes held a position equivalent to being long the underlying as well as being long four calls in order to create the five-times upside leverage.

"Suppose it's a one-for-one upside. You're giving up 4.5% multiplied by four years, which is 18% worth of value, which you can use to buy the four calls. Don't forget, all these calls are capped, although the cap is 20% out-of-the money," he said.

"It's a combination of Citibank credit spreads, although they are not that high, and dividends. Essentially, the whole pricing here is based on the use of the high dividend yield.

"Even without leverage, you're supposed to get 4.5% a year. Would you forgo 4.5% for leverage? That's the bet."

Most leveraged notes have an embedded leverage factor comprised between one-and-a-half and three. Five times is more unusual, this structurer said, although "not unheard of."

"Highly leveraged notes have been seen before, but it's not the norm. Maybe we're seeing the beginning of a trend, who knows? Now that it's being shown ... if there is enough demand, we may see more," he said.

High-dividend-paying assets used in the underlying are the decisive tool to build those products. But volatility is also part of the picture, he noted.

"The low volatility helps the structure. You're buying four extra calls and you're long the underlying," he said.

Opportunistic bet

The notes represent a bullish play on the European stock index, which may be timely, an industry source said.

"It's a pretty good structure, especially if you think that Europe has been oversold," he added.

"You get a good leverage on an opportunistic structure."

The performance of the Euro Stoxx 50 index is flat for the year, compared with the S&P 500, which has already gained 3.4%.

The euro zone benchmark has only appreciated by 3.55% in the past 12 months, lagging the S&P 500's 11% return during the same time. Due to the 2008-09 financial crisis, the Euro Stoxx has lost 30% in the past five years, a sharp contrast with the S&P 500, which has increased by 11% during that time.

This source agreed that the 4.5% dividend yield contributed to the attractive upside.

"High dividends will give you better terms," he said.

Given the eye-catching upside of the deal, some may ask why the deal size was so small.

"Generally speaking, unlike the European investor, the U.S. investor is a very domestic investor. You don't see too much of interest outside of the U.S. broadly speaking," the source said.

"An S&P deal would have been a lot more subscribed.

"It may also be a factor of the distribution channel. I'm guessing it was sold to high-net-worth investors, especially if UBS was the distributor. I don't think it was retail. Retail investors are just trading on the news."

Citigroup Global Markets Inc. was the underwriter. Distribution was through UBS Financial Services Inc.

The notes (Cusip: 173095605) priced on Feb. 14.

The fees were 2.5%.

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