Citigroup's unusual nine-month 6.75%-8.75% ELKS linked to Ford and Nokia aim to reduce risk

By Emma Trincal

New York, March 14 - Citigroup Funding Inc. is prepping an offering of reverse convertibles linked to a basket of two stocks, a structure that sources said is unusual and designed to reduce downside risk.

Citigroup plans to price 6.75% to 8.75% annualized Equity LinKed Securities due Dec. 12, 2011 linked to equal weights of the common stock of Ford Motor Co. and the American Depositary Receipts of Nokia Corp., according to a 424B2 filing with the Securities and Exchange Commission.

Interest will be payable monthly. The exact rate will be set at pricing.

The payout at maturity will be par of $10 unless the basket falls to or below 80% of its initial level during the life of the notes, in which case the payout will be a number of shares of Ford stock and ADRs of Nokia or, at the investor's option, an equivalent cash amount.

For each basket component, the number of shares will be equal to 50% divided by its initial price multiplied by 10.

Safety net

"I haven't seen a two-stock combo recently. Last time I saw something similar, it was two stocks and gold," said John Farrall, senior vice president, director of derivatives strategies at PNC Wealth Management.

"Doing both stocks instead of one might be safer," he added.

The two stocks reduce the chance of breaching the downside barrier, he explained, which is the same as saying that there is a lower chance that the embedded put option will be exercised.

"The risk is even lower when the two stocks are not correlated," he noted.

"The attraction of a dual-stock reverse convertible is not necessarily that it lowers the volatility or the pricing. But it might be safer. These are two stocks in two different sectors. Both have fallen quite a bit. Do you feel better taking the bet on one of them or the two of them?"

Lower coupon

Paul Weisbruch, an options trader at Street One Financial, said that linking a reverse convertible to a pair of stocks rather than a single name reduced risk. As a result, it allowed the issuer to pay a lower coupon.

Investors in a reverse convertible are short a put, and they get compensated with a coupon for taking this position. If the put option is less likely to be exercised - or the basket price less likely to fall below 80% in this example - "then I would think the issuer wouldn't need to pay that much," Weisbruch said.

"The more stocks you get, the more diversified the basket. So this is definitely less volatile than just one stock. In addition, Ford and Nokia are completely unrelated stocks. Take two uncorrelated assets, put them together, it dampens the overall beta, as they should not move in lockstep," he said.

"They tried to lower the volatility of the underlying basket. It looks like it's the way this deal is set up. If one sector falls, the other may offset the decline.

"They took two large-cap names in two different sectors. These are two household names. Now, why these two names, I couldn't tell you."

Still not diversified

For Carl Kunhardt, director of investment management and research at Quest Capital Management, using two stocks rather than one may diminish the volatility of the underlying. But it's still not enough to convince him to invest in the product.

"The two stocks are not highly correlated: a car company and a mobile phone company. The basic structure of the notes doesn't bother me. The parameters are OK," he said.

"But I wouldn't do it in my portfolio because I don't see it adding real value.

"It's not a sector play. These two are uncorrelated sectors. If you're trying to make a sector play, you're much better off with an [exchange-traded fund]."

Kunhardt said that while the two stocks show little if no correlation, the underlying basket remains poorly diversified.

"If the market declines, both Ford and Nokia will go down. It's not as if your note was tied to an index," he said.

In general, the financial adviser picks structured notes linked to an index rather than a single name. The same would hold true for two names, he said.

"I don't believe having two stocks instead of just one reduces the volatility all that much. And since I don't believe in single stocks, I wouldn't use that note. With a single stock, you should know the company as if you were its owner because you are. You own the stock. We don't follow companies that closely. With two stocks, it's pretty much the same thing.

"If I had to take that much of a focused exposure, I would go with an ETF where you don't have to take all the business, management and credit risk that go along with stocks."

The notes (Cusip: 17316G222) are expected to price and settle in March.

Citigroup Global Markets Inc. is the underwriter.

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