Citigroup’s barrier digital notes on 10-year CMS rate may fit bear market outlook, cycle

By Emma Trincal

New York, May 7 – If history is any guide, a rate-linked note promising a fixed return if Treasury yields increase or even decline up to a point could be an attractive investment, according to a contrarian investor who is bearish on the stock market.

Citigroup Global Markets Holdings Inc.’s 0% enhanced barrier digital securities due May 24, 2022 linked to the 10-year Constant Maturity Swap rate will pay a digital return of 7.45% if the final 10-year CMS rate is greater than or equal to the final barrier value, 70% of the initial CMS rate, according to a 424B2 filing with the Securities and Exchange Commission.

If the final 10-year CMS rate is less than the final barrier value, investors will be fully exposed to the decline of the CMS rate from its initial level.

CMS rates are often used as proxies for the Treasury yields even though they may not exactly match the Treasury yield.

Investors in the notes expect rates to be either higher at maturity or lower as long as the decline does not exceed 30%, said Steven Jon Kaplan, founder and portfolio manager of True Contrarian Investments.

Insiders selling

This view and the note’s timeframe matched his own market outlook for both the stock and Treasury markets.

“Smart money and insiders have been selling stocks at record highs while average investors have been piling in. The more sophisticated investors know that asset prices have reached bubble levels,” he said.

For those insiders, the bear market is underway. Some signs include the Nasdaq Composite index unable to break through its most recent high of April 29, he said.

On Friday, the technology-heavy benchmark was down 3.8% for the week.

Another bearish signal, he noted, is the current levels of semiconductors and small cap stocks, which have topped out ahead of the broader indexes.

Inflation narrative

“The widespread fear of inflation, which was constantly in the headlines, has contributed to push up yields higher six weeks ago. Bond prices became much cheaper than they were before, prompting smart money to buy Treasuries in March when yields were at their highest, as opposed to the crowd still frantically piling into stocks and funds, ignoring the risk,” he said.

On March 30, the 10-year Treasury yield hit its highest level since January 2020 at 1.77%.

“Insiders began to dump stocks at record levels starting in January but also in February and March. They recognized that we’re heading for a big drop in equities,” he said.

Parking money in Treasuries at much higher yields makes sense for those betting on a stock market pullback. Returns on government bonds are higher than cash and the asset class provides the necessary liquidity to buy stocks later at deflated prices, he explained.

Yields went up at the time because investors reacted to news of trillions of dollars in stimulus packages and post-Covid economic boom, spurring inflation chatter in the media, he added.

“But once again, they reacted too late. The average investor always gets it wrong because they tend to react emotionally when that part of the game is already over,” he said.

“Inflation is a force to reckon with but not necessarily over the short-term,” he said.

“Instead of worrying about an overextended stock market, the average Joe keeps on pushing higher valuations across a wide spectrum of assets, not just stocks, but also housing, crypto, commodities...”

Since their March peak, Treasury yields have somewhat settled down, the 10-year trading at around 1.58%.

At this point, the bond market is not doing much, he said.

“Treasuries are not cheap enough to buy and not expensive enough to sell,” he said.

Not in lockstep

Kaplan said the notes may be a successful investment due to the short timeframe of the trade during which rapid market cycles should unfold. His view reflects a contrarian approach, and an observation of what insiders are doing, which is the opposite of mainstream.

“The average person responds to things that the sophisticated investors anticipate before them. Right now, the herd is buying stocks at their highest and sophisticated investors are sitting in liquid assets waiting for the buying opportunity that will come soon after the collapse,” he said.

Individual investors are guided by emotions, he explained. The so-called “FOMO” or “fear of missing out” can be hard to contain when the averages keep on climbing to new records almost daily.

Some encouraging economic data, such as the recently released 6.4% growth in GDP, the perspective of a strong post-Covid rebound and solid earnings have fed the bullish momentum.

Even when the data are not as positive – as it was the case on Friday with a disappointing job report, the bull is still running. On Friday, both the S&P 500 index and the Dow Jones industrial average hit new all-time highs.

Bloody summer

“I expect a big drop sometime in the next few months, possibly this summer,” Kaplan said.

Shortly ahead of the bottom, insiders and institutional investors will sell their Treasury positions to buy stocks at deep discounts while the rest of the market will be selling their equity holdings in panic, he explained.

“The wealthiest investors start buying stocks and selling Treasuries before the stock market finishes its correction. Yields constantly go up before the stock market reaches its bottom. It’s a historical pattern observed on most bear markets. So, we’ll see yields moving back up at that time,” he said.

Short-lived bond rally

Not surprisingly, the “reactive” investor will do just the opposite – selling stocks at bottom and buying government bonds in a flight to quality, he noted.

One trend does not necessarily offset the other since the smart money group tends to act ahead of the crowd, he explained.

“Yields could go down when the stock market collapses as everyone will be desperately jumping into Treasuries. But this is probably not going to last,” he said.

Bear markets tend to be brief. Kaplan’s scenario could unfold with a positive outcome for the notes within the short timeframe of the product.

“One year is more than enough. Even if yields start to drop again with people frantically dumping their stocks and buying Treasuries, this trend is not going to last because it’s an extreme inflexion point, a panic, which will revert itself as it always has,” he said.

After the carnage

He pointed to the brevity of bear markets. Half of the percentage drop of any bear market historically happens in a noticeably short time, he said.

“There will probably be successive legs in this downturn. You’ll have a big drop first. Then it will be jumping all around. Bear markets are never a linear process. But usually after the initial collapse, the inflation resurgence theme starts to assert itself again,” he said.

The greater the stock market decline, the more valuations will regain credibility.

“After the shock, stocks will be attractively priced again prompting more people to buy. The market will recover and with that, inflationary pressures will become a driving force again,” he said.

Both developments will contribute to higher yields, which is what buyers of the notes are betting on.

“Once we get to May 2022, which is when the notes mature, I can see yields higher, not just higher than the -30% barrier. Higher than today.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price on May 7 and settle on May 11.

The Cusip number is 17329FNP5.

The fee is 1%.

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