Citigroup’s fixed-to-floaters tied to 10-year CMS rate offer 6% teaser rate for two years

By Emma Trincal

New York, July 19 – Citigroup Global Markets Holdings Inc.’s fixed-to-floating rate notes due Aug. 7, 2028 linked to the 10-year Constant Maturity Swap rate give investors an alternative to a 10-year government bond with higher yield but less liquidity as well as exposure to a bank’s credit risk.

Interest will be 6% for the first two years, according to a 424B2 filing with the Securities and Exchange Commission.

After that, interest will be equal to 1.05 times the 10-year CMS rate, subject to a minimum interest rate of 0%. Interest will be payable quarterly.

The payout at maturity will be par.

Market environment

“We are in a period of rising interest rates and we believe this will continue for some time,” said Matt Medeiros, president and chief executive of the Institute for Wealth Management.

“There’s an added benefit here with the 6% per year on the first two years.

“They give you a tiny bit of leverage too, but it’s not much. The real benefits are the fixed rate in the beginning and the principal protection at maturity.”

Red flag

But for this adviser these positive features came with a significant drawback.

“You’re taking the issuer’s risk versus having the full faith and credit of the government. With the renewed focus on the banks and the banks’ stress tests, we think there will be continued concerns in this sector. We saw banks defaulting during the 2008 financial crisis. It’s a prudent thing to take into account credit risk at all times but the last crisis has definitely contributed to raise awareness about those issues.”

If investors are willing to do the “tradeoff” by agreeing to be subject to credit risk in exchange for a higher yield, the notes may have their place in a portfolio. But Medeiros would probably not consider this option.

“It’s not a bad deal. It may be a good deal depending on the direction of interest rates and the magnitude of their move. I just think it’s a long tenor,” he said.

“Certainly, many of us are trying to search for ways to pick up some income. This is one among many examples.”

Yield curve

Another concern was the lack of liquidity of the notes, said Steve Doucette, financial adviser at Proctor Financial.

“It’s a long-term note. You get 6% on the first two years... then you’re locking yourself for eight more,” he said.

“What happens if we go into a recession? The yield curve might be inverted.”

The curve is currently flattening, with the spread between the short and the long-end narrowing. The two-year for instance has a yield of only 2.6% versus 2.85% for the 10-year.

As a result, there is little benefit in buying longer-dated Treasuries.

“You’re picking up only 25 basis points by extending the duration from two to 10 years. That’s if the curve is flat. If it is inverted, it’s a losing game,” he said.

Little liquidity

A buyer of U.S. Treasuries on the other hand would benefit from one of the most liquid markets in the world.

“Treasuries are very liquid. Unlike this structured note, you can sell Treasuries anytime,” he said.

The prospectus pointed indeed to the risk of having “limited or no liquidity” when investing in the product and urging investors to be willing to hold the notes to maturity.

Equity alternative

“This thing works if rates go up and you ride it up wherever they go. But if it doesn’t happen, your money is tied up. In theory you could earn zero interest rate.

Such scenario however is highly unlikely unless on the basis of real interest rates. The 10-year nominal rate closed at an all-time low two years ago at 1.37%.

“I understand that this is a fixed-income substitute. But I think you can do better with equities without taking on too much extra risk.

“I’d much rather buy one of those principal-protected notes on equity. They’re shorter. You get 90% or 95% of your principal guaranteed. And you can generate a much higher return,” he said.

The notes are guaranteed by Citigroup, Inc.

Citigroup Global Markets Inc. is the agent.

The notes are expected to price on Aug. 2 and settle on Aug. 7.

The Cusip number is 17324CY83.

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