Citi’s CMS spread range accrual notes tied to indexes offer high teaser rate for two years

By Emma Trincal

New York, Jan. 16 – Citigroup Global Markets Holdings Inc.’s callable fixed-to-floating rate CMS spread range accrual securities due Jan. 31, 2034 linked to the worst performing of the S&P 500 index, the Russell 2000 index and the Euro Stoxx 50 index should appeal to investors who expect the spread between long- and short-term yield to widen sooner than later, a fixed-income trader said.

The interest rate will be 11% for the first two years. After that, the interest rate will be the contingent rate multiplied by the proportion of days on which each index closes at or above its barrier level, 70% of its initial level, according to a 424B2 filing with the Securities and Exchange Commission.

The contingent rate will be an annual rate equal to 30 times the spread of the 30-year Constant Maturity Swap rate over the two-year CMS rate, subject to a minimum of zero and a maximum of 10% per year. Interest will be payable quarterly.

Beginning Jan. 31, 2020, the notes will be callable at par on any interest payment date.

If the worst-performing index finishes at or above its barrier level, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% that the worst-performing index declines from its initial level.

Barrier

“The 11% fixed rate on the first two years is pretty attractive,” said a market participant.

“But the 10% cap is very attractive too and so is the 30 times leverage. The 15-year maturity...I’m comfortable with this too.”

Principal-at-risk over a 15-year maturity used to be the exception, he said. But it is no longer the case.

“It’s so expensive to issue notes with full-principal protection. You can’t get a good leverage or a decent coupon,” he said.

The 70% barrier was a concern.

“It’s pretty standard to have a barrier now. It’s been like that for a few years. But it’s a worst-of. Is it enough? When you’re managing assets like these guys I talk to, I don’t think it is. They want more.”

A 60% barrier would be more appropriate, he said.

“I’ve had more success with bigger barriers and higher caps even if it means giving up some leverage,” he said.

Calling you

Evaluating the strength of the principal repayment barrier at maturity is important, he said. It’s part of accounting for the long-term risk introduced by the equity component, especially with three underliers.

More realistically though investors have to weigh in the reinvestment risk, which surfaces two years after the issue date when the rate converts into a floater. That’s when the issuer is entitled to call the notes.

“The great thing with this note is you’re not getting called for the first two years and you get 11% a year,” he said.

“After that your fate depends on the shape of the curve. Your coupon is limited if it’s flat or if we get an inverted curve. The curve widens, the coupon rises. Then at some point, they will call it.”

Investors tend to be unhappy with such outcome.

“They’ll say: wait a minute, I just rode this thing on a flat curve and now you’re calling it on me? This is why some customers don’t like buying callable notes.”

But the call is also what allows issuers to price the high initial fixed rate.

Range bound spread

The variable coupon would significantly increase if the yield curve widened thanks to the 30x leverage factor, he said.

The current spread of the 30-year CMS rate over the two-year CMS rate is 15 basis points. If the leveraged factor was applied today, investors would receive a 4.5% annual coupon rate, he explained.

“If you don’t get called right away and two years from now the spread is at 0.2%, you’d get 6%. It’s a nice return. I like it.

The 10% cap would be nearly hit at a 33 bps spread.

“I’d want the spread to stay in the 20 or 25 range. Once it gets more than that you get called,” he said.

The equity factor

The risk of not getting paid a coupon or to receive a meager one was another important part of investors’ due diligence.

“The question is: are we going to go flatter to zero or 5 bps? If the curve flattens more and inverts you’re losing your coupon. That’s an important risk to consider,” he said.

Along with the yield curve, investors watching how much they get in floating rate should keep an eye on the equity market. The range accrual component of the payout will also determine how much they will get paid and for how long.

“If you buy a steepener, you expect your coupon to rise. What are the risks? They can call it and that’s the end of the deal...or the market could tank, in which case you’re getting a lower coupon.

“I think it’s more likely you’re going to get called,” he said.

“Even though the 70% barrier is a bit tight, I think the curve will widen out before the market will sell off 30%.”

Mean reversion

A fixed income trader also liked the notes.

“I like the two year at 11%. That’s pretty attractive. After that, the shape of the curve will determine the outcome,” the trader said.

“People like steepeners because they like the higher teaser rates. They also look at the historical yield spreads.

“The spreads are much below their historical norm today,” he added.

The 30-year minus 2-year long-term historical average is 200 bps.

Asked about the amount of leverage, this trader said that it depended on the investor’s view on the yield curve’s shape in the near term.

Investors tend to arbitrage between having a high initial fixed-rate and a high leverage factor, he explained.

Timing the widening

“When you invest in those long-term steepeners you don’t expect the curve to stay flat or to be inverted. You see the spread between the long and the short end of the curve widening. But depending on how fast you think it will happen you may have a preference for the leverage versus the guaranteed coupon,” he said.

This is somehow similar to leveraged return notes on equity. A less bullish investor will demand more leverage than an aggressive bull whose focus will be on a higher cap.

“You can get other deals with lower teaser rates and 50 times the spread instead of 30. It depends on what you’re thinking,” he said.

“If you think the curve will stay flat for a long time, you’re better off with the bigger multiple.

“If you think it will happen relatively soon, then you don’t need to lever up the spread that much. You’re better off with a higher fixed rate.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes will price Jan. 29.

The Cusip number is 17326YND4.

© 2015 Prospect News.
All content on this website is protected by copyright law in the U.S. and elsewhere. For the use of the person downloading only.
Redistribution and copying are prohibited by law without written permission in advance from Prospect News.
Redistribution or copying includes e-mailing, printing multiple copies or any other form of reproduction.