Citigroup's leveraged, uncapped notes tied to S&P offer good terms but tenor seen as too long

By Emma Trincal

New York, Dec. 23 - Citigroup Inc.'s 0% Accelerated Return Notes due Sept. 25, 2017 linked to the S&P 500 index offer bullish investors a good alternative to a direct equity investment, sources said. In particular the absence of a cap combined with upside leverage and downside protection was seen as appealing. The duration of the product, however, is a concern, they added.

The payout at maturity will be par plus at least 120% of any index gain, with the exact leverage factor to be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

Investors will receive par if the index falls by up to 25% and will be fully exposed to losses from the initial level if it falls by more than 25%.

"There is no cap and there is some protection. For bulls the risk reward tradeoff makes sense," said Kirk Chisholm, principal and wealth manager at NUA Advisors.

Good tradeoff for bulls

Investors as with most structured notes would have to forego the 1.85% annual dividend yield paid by the underlying index over a period of 3.75 years, which represented a total opportunity cost of nearly 7%, Chisholm noted. Yet, the product remained attractive for bulls, he said.

"I think it's still a reasonable tradeoff. If the market continues to rise, you'll be getting a better alternative to the S&P because you're getting the leverage," said Chisholm.

"If the S&P continues to be up at the same pace it has been going up, then obviously it's worth investing in this.

"But you do have to be bullish. Someone less bullish may be looking at the fundamentals. Corporate profits in particular have been abnormally high, even stretched from a historical standpoint. The argument could be made that returns over the next four years could be much more subdued than what we've seen recently with the bull market.

"But for somebody looking for exposure to the S&P now, the tradeoff is attractive, making this note a better play than the index itself.

"You're giving up 7% over almost four years. But you're getting 25% downside protection and 1.2 times leverage."

Too long

The duration, however, was Chisholm's main objection.

"Personally, I would be cautious at this time," he said.

"Four years is a long time to invest in the S&P. The fact that the markets are moving based on the Federal Reserve decisions can't be ignored. A lot can be happening in four years.

"The maturity timeframe is a bit too long for my liking," he said.

"This is a good structure for the upside. But taking exposure to the S&P is a more risky proposition that investing in another asset class," he said.

Conceptually sound

Steven Foldes, president and chief executive of Foldes Financial Management LLC, said that he liked most of the product's features. The structure in his view was an alternative to other products that tend to excessively cap the upside in order to offer leverage and downside protection.

But he also found the tenor of the notes longer than his required limits.

"This is almost four years. We typically don't like to go much beyond two years. Given the low volatility in the market, we've extended our limit to three years. But something that's almost four years is probably too long for us," he said.

However, he said that he liked the other terms of the product.

"Conceptually it's a good structure. I like the note because it has a substantial barrier. It's not a buffered note. It's a barrier note and we recognize it's not an absolute protection. Once the index drops below the barrier, you're long only. But 75% is a nice level of protection.

"The upside is appealing because the leverage gives you something better than a long only exposure to the benchmark."

Foldes did not see in the non-payment of dividend any serious drawback, arguing that investors, thanks to the leverage, were able to get back the dividends with a "modest return" of about 5.85% over the length of the term.

Overcoming low vol.

"The only real problem is the maturity. From my perspective, it's a fairly long holding period," he said.

"I agree that it's nice not to have a cap. We like buffered notes and we found in our research over the last six months that it's very challenging to get those types of products at attractive levels."

"We've priced several leveraged notes with downside protection and we were capped out at some very modest levels. Ultimately we decided to buy mutual funds and ETFs instead," he said.

The challenge for structured notes investors who want a combination of upside leverage and downside protection has been the low levels of volatility, as they fail to give issuers enough room to price attractive term, he explained.

In order to get an acceptable downside protection level, investors have had to either accept caps - often low ones - or extend duration, he said.

"This note is the alternative to capping the upside. It's the longer-duration solution. We prefer that type of structure rather than a shorter-dated product with a cap simply because having a cap can be a killer. Caps are so low, they are forcing us into mutual funds.

"That said, it's a little bit too long.

"We are facing this challenging environment. It has become increasingly difficult to find attractive leveraged deals with protection. The volatility on the S&P especially is too low. Perhaps a solution would be to study what types of terms we would get using the same structure but applied to a different asset class, small caps; international developed markets; or emerging markets for instance," he said.

The notes (Cusip: 1730T0D71) will settle on Thursday.

Citigroup Global Markets Inc. is the agent.

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