Citigroup's market-linked notes tied to S&P 500 offer principal protection on shorter tenor

By Emma Trincal

New York, Feb. 10 - Citigroup Inc.'s market-linked notes due Aug. 29, 2019 tied to the S&P 500 index offer conservative investors an attractive way to get full principal repayment at maturity over a shorter period of time than most principal-protected deals, sources said.

The trade-off is to accept less than 100% of the index return on the upside. But the upside is not capped, according to an FWP filing with the Securities and Exchange Commission.

If the index return is positive, the payout at maturity will be par plus 90% to 100% of the index return. The exact upside participation rate will be set at pricing.

If the index return is zero or negative, investors will receive par.

Protection, shorter tenor

Carl Kunhardt, wealth adviser at Quest Capital Management, said that the risk-return profile of the notes is very attractive.

"You get 90% of the gains and not 100%. That's the cost of protection," he said.

He added that the structure is a perfect illustration of why he invests in structured notes.

"I use structured notes for hedging or for enhancing my returns," he said.

"It's pretty good to be able to get the return of most of the index and get full downside protection."

The less-than-100% participation rate enables the issuer to offer the full protection over a shorter period of time.

"Those principal-protected notes can go as long as seven or eight years," he said.

"Sure, you still have your money invested for five and a-half years. But this would not be an issue for us. I have very few families for which a short time horizon is that important. Besides, it's not 100% of my portfolio, and other pieces of my portfolio are short-term."

Wide range of uses

Because the notes offer upside participation in the equity benchmark while ensuring protection against a market downturn, they could be employed in a variety of investors' portfolios, he said.

"I can almost see it as a part of my equity allocation. In fact, it is a core equity holding," he said.

"There isn't one single portfolio I wouldn't put that in except perhaps in the aggressive portfolio.

"I am participating in the index. Granted, I'm paying a 10% haircut, but I can't lose money from the market. There is always credit risk, but that's true of all structured notes.

"So you get almost the full upside, and you get the full downside. I love it.

"When I look at what a perfect structured note represents for me, I can see this is one of them. I want this Cusip."

Better than a cap

Most of the issuers pricing fully principal-protected notes have to extend maturities in order to price the structure in a low interest rate environment, he said. The structure is most often characterized by a longer maturity and a cap with at least 100% upside participation.

Kunhardt said that a 90% upside participation rate is more attractive than a cap.

"The use of this less-than-100% participation is very, very rare. But then principal protection has become very rare too," he said.

"It's better than having a cap. With the cap, the counterparty is the only one making money. When an issuer like Citi puts a note together, they're just putting it together. Should you exceed your cap, Citi has already collected its transaction fee. Whatever is above the cap goes to the counterparty.

"With this deal, 10% is your cost for the protection. That 10% goes to the counterparty. But it doesn't stop the participation on your end, while if there is a cap, your participation stops right there. One you hit the cap, that's it. You will not get anything more than the cap.

"While, here, even with the haircut, I have the potential for unlimited return. It's only limited by how far the index goes up. I really like that one."

More meat

Another appealing aspect of the structure is its simplicity.

"The smoke and mirrors, the bells and whistles are not ringing anybody's bell anymore," he said.

"Issuers have been offering products that are outside the box. But investors are saying give me something with meat. I'm tired of the hors d'oeuvres. A lot of the deals we're seeing don't have a lot of meat in it.

"That's a meaningful product. There is a cost to it. But there is a cost to everything. You get 100% principal protection at a cost of 10%. That's pretty good."

Even the 3% fee is acceptable, he said.

"It's on the upper side, but it's in line. It's not something that would keep me from doing it," he said.

Income preferred

Mark Dueholm, chief trader at FISN, a division of Landolt Securities, had a different take on the product, giving preference to having a coupon.

"Most of our customers are looking for income. This one doesn't offer any income," he said.

"They're cutting the upside participation rate in order to shorten the maturity. I've seen a lot of longer-dated ones. This formula is much less common. With a seven year, you could get 100% participation. I haven't seen too many of those shorter ones with less than one-to-one on the upside," he said.

Dueholm said that his focus is mainly on range accrual notes.

"We tend to do mostly income deals where you get paid up front a high interest rate of 7% to 10% as long as the stock or the index doesn't fall below a certain level. You also have a Libor contingency component. That's where we find the best of success," he said.

Giving up some of the upside for a shorter term would not necessarily be something Dueholm would consider.

"We haven't found our clients to be tired of the longer durations. Also we feel that the longer the product, the better. At least this is the reasoning for those range accrual notes that we've used. They used to be fully protected, and they're not anymore. They typically have a 50% barrier on the downside. But 50% is pretty conservative, and it can give you a high coupon. I'd rather not have the full principal protection and get paid the income. Over a 15-year period, it's unlikely that the index will drop by more than 50%. It's much more likely to happen over a shorter period of time. We're more comfortable with income over a longer period of time," he said.

No dividends

Juin Chin, senior investment analyst at Modera Wealth Management, LLC, pointed to two important aspects of the structure, dividends and credit risk exposure.

"It's a five and a-half year, and the problem is that you don't get any dividend payout during that time," Chin said.

"When you compound the exclusion of dividends over five and a-half years, you end up losing 11% in total return performance. And that's just the minimum. If the S&P 500 appreciates, then future total return is diminished even more by virtue of compounding.

"So if the market turns south, you are getting principal protection, which is good. But you're locked in for a pretty long period of time.

"It's structured like a bond that lets you participate to some or most of the equity price returns, but you're not getting paid the dividend."

As a result, the notes are not necessarily a good fit for all investors but may be suitable for a few more conservative players.

"It depends on what you're trying to achieve. If you want to get market exposure while taking the market risk off the table, investing in these notes may be a good idea," he said.

But investors still remain subject to counterparty risk, he warned.

"In 2008, Lehman issued a lot of structured notes, and investors got pennies on the dollar. That's one of those events when you need the protection the most; that's when the counterparty risk rears its ugly head. It's a tail risk probability. The chances of this happening again are very slim. But it's something you still need to worry about. Just because the issuer guarantees your principal does not mean you will get your money back in the event of a default," he said.

The notes (Cusip: 1730T0H36) are expected to price Feb. 25.

Citigroup Global Markets Inc. is the underwriter.

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