Citigroup's notes with contingent coupon linked to S&P 500 seen as hedge against inflation

By Emma Trincal

New York, Nov. 4 - Citigroup Funding Inc.'s upcoming notes with a variable and contingent coupon tied to the S&P 500 index are designed for investors who anticipate higher rates over the next decade without envisioning a serious and long-lasting equity bear market, sources said.

The notes will mature Nov. 19, 2020, according to an FWP filing with the Securities and Exchange Commission.

The coupon will be 6% for the first year. Beginning Nov. 19, 2011, the interest rate will be Libor plus 250 basis points, subject to a cap of 10% per year, multiplied by the proportion of days on which the S&P 500 closes above 800. Interest will be payable quarterly.

The payout at maturity will be par.

Risk factors

The payment of a fixed-rate coupon is only for the first year, the prospectus said. After that, the coupon is both variable and contingent upon the performance of the S&P 500.

"The notes are not suitable for investors who require regular market interest payments," the prospectus said in the risk factors section.

Investors could end up earning less in interest than a conventional debt security if the days during which the S&P 500 is below 800 accumulate, reducing the amount of coupon paid, according to the filing.

Another risk is the 10% cap on the annual coupon.

Income enhancement

For Steve Doucette, financial adviser at Proctor Financial, those risks are manageable.

"Will the S&P [500] go down below 800, and how long will it be down over 10 years? I think the risk is not huge if you look at how long the benchmark stayed below that threshold in the past," he said.

Currently at about 1,200, the S&P 500 traded below the 800 mark for 24 days between February and March of last year. The benchmark had not broken the 800 threshold since 1997.

Doucette looked at the current Libor of 30 basis points, to which the notes add 250 bps.

"I consider 2.5%, even 3%, as cash level rates.

"It's a reasonably safe way to pick up a little bit of extra yield.

"There is a risk not to earn your coupon if the market crashes, but it's a low risk. And you're not losing your principal."

However, traditional fixed-income investors may not be attracted to the product, he said.

"If you're looking for income and the market collapses, your principal is locked up. That's a problem."

Doucette said that he would not be in the market for this product due to the long tenor. He only invests in notes with a term of two years or less.

"I would prefer a short-term duration bond fund with limited interest-rate risk.

"But I think it's a reasonable instrument to add a little bit more yield into your portfolio. It looks like if you give up some coupon, it's only going to be for a short amount of time."

Navigating inflation

Some saw in the notes a way to hedge inflation and to protect one's income against rising interest rates.

"To lose the coupon, you would need the S&P 500 to fall by a third from what it's at now. You would need a double-dip [recession], and it's not happening. Not with a $600 billion stimulus," he said, alluding to the Federal Reserve Board's announcement Wednesday that it will purchase $600 billion of longer-term Treasuries in a second round of quantitative easing.

"And finally, you get 2.5% above Libor, and we know that Libor will grow because rates are going to go up, as we're entering into an inflationary environment."

"I like it a lot," a fixed-income trader said.

The notes (Cusip 1730T0KY4) are expected to price Nov. 16 and settle Nov. 19.

Citigroup Global Markets Inc. is the underwriter.

Fees are 2.25%.

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