Citigroup's 18%-19% autocallables linked to Tesla Motors a fit for speculative investors only

By Emma Trincal

New York, Jan. 7 - Citigroup Inc.'s autocallable equity-linked securities due Jan. 29, 2015 linked to the common stock of Tesla Motors, Inc. represent a highly speculative bet given that the underlying stock was one of the fastest-growing stocks of last year, which raises red flags about a potential pullback, sources said.

The interest rate paid quarterly on the notes is expected to be 18% to 19% per year and will be set at pricing, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be called at par plus interest if Tesla Motors shares close at or above the initial share price on any autocall observation date, which occur quarterly.

If the notes are not called and the final share price is greater than or equal to the downside threshold price, 75% of the initial share price, the payout at maturity will be par. Otherwise, investors will receive a number of Tesla Motors shares equal to $1,000 divided by the initial share price or, at the issuer's option, a cash amount equal to the value of those shares.

For Tom Balcom, founder of 1650 Wealth Management, the investment will perform best if the growth of the stock price is moderate.

"What kind of investors would do it? If the stock has a good run, you won't perform as well. If it goes down, you don't want to invest in it because beyond 25% you no longer have the protection," he said.

"The only way to win with this product is if Tesla shares go up moderately. If it drops, your capital is tied up for one year, even if you take no loss. If it goes up at the pace it did last year, you would be better off owning the stock. The notes would significantly underperform the equity, and that's not good either."

The share price of Tesla last year rose 333%.

Speculators only

"It would have to be for a speculative account, someone who wants to have exposure to the name and who doesn't expect the stock to rally above the 18% coupon. That person should be aware of the downside risk too. The risk on the downside is greater than the potential on the upside," he said.

Structures such as this one are the equivalent of an investor selling volatility to the issuer, he said.

"The more volatile the stock, the more juicy the potential coupon because it's the premium that you sell," he said.

"It's similar to writing a put on the stock. In exchange for writing a put to the issuer, the investor gets the 18% coupon," he said.

Structured notes, however, offer the benefit of being easier than options to manage for a financial adviser.

For investors, the advantage is that they are not required to lay out the capital required to buy the 100 shares that comes with an option contract.

"The issuer is putting together the structure for you. You can just invest $1,000 and put it into an IRA. It's one easy Cusip number," he said.

Even the 2.75% fee associated with the product is "not a bad fee," as long as the investor "knows what he is buying," he said.

Know the risks

"In particular, don't get enamored by the 18% potential return. Be sure to understand how the structure is constructed and what your risk is," he said.

"There are basically four scenarios if the notes don't get called before maturity. The stock could be up and above 18%; that's the upside risk. The stock could be up by less than 18%, which is the best outcome for you. Or it could be down but not by more than 25%, and you keep your coupon without losing any principal. Finally, it can decline below the 75% threshold and you start losing principal.

"A stock with a parabolic return like Tesla should really raise concerns. Is this growth sustainable? The stock is very volatile. And the problem with those short-volatility structures is that you can't do a note like that on a non-volatile stock.

"As a speculative equity replacement for a well-informed investor, I may consider it. But I would not have an investor use it as fixed-income replacement."

Volatile underlying

Donald McCoy, financial adviser at Planners Financial Services, said the risk reward was not all that attractive.

"First of all, we've got a note tied to a very volatile stock. Tesla can easily crash this 25% limit on the protection, and your downside is then unlimited," McCoy said.

"You have the 18% coupon, which gives you a nice little buffer. But given the moves of the stock, you could still lose principal easily. I mean in theory, you could lose up to 82% of principal.

"All you have to do is look at the chart. From early October to the end of November, in less than two months the stock dropped 38%. If it happens to you at maturity, the coupon protects you from losing the entire 38% drop, but you're still down 20%. There's just a lot of principal at risk with this stock.

"And on the upside they're only giving you 18% on a stock that went up 333% last year."

Call risk

McCoy said that for the trade to make sense, the notes would have to not be called while the stock finishes positive.

"For this trade to work, for an investor to earn the full 18% return, the stock would have to be lower for nine months and shoot up at the end of the year. The probabilities of that happening are pretty low. You could get called after three months and pocket your 4.5% return. Some aggressive investors may like it, but typically people would prefer to get the full 18% return. If you do get called early, it's a short-term win, but the risk you take to get there is certainly high," he said.

"I can see why someone would choose to use this product to create yield. But I just wouldn't do that simply because people looking for yield don't want that kind of risk."

Citigroup Global Markets Inc. is the underwriter.

The notes are expected to price Jan. 24.

The Cusip number is 1730T0F79.

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