CIBC’s 7.5% STEP Income on Citigroup benefits from volatility spike but risk remains

By Emma Trincal

New York, Oct. 10 – Canadian Imperial Bank of Commerce’s 7.5% STEP Income Securities due November 2019 linked to the common stock of Citigroup Inc. give investors enhanced income without the use of several underliers or a contingent coupon. The reverse convertible-like structure was made possible with the recent market turmoil, which has increased risk and premium, a market participant said.

However, the lack of any barrier or buffer should make potential buyers cautious about the risk on the downside amid the current sell-off, an analyst noted.

Interest will be payable quarterly, according to an FWP filing with the Securities and Exchange Commission.

If the stock price finishes at or above the step level – 107.5% of the initial level – the payout at maturity will be par of $10 plus a step payment of 1% to 5% that will be set at pricing.

If the stock finishes at or above the initial level but below the step level, the payout at maturity will be par.

Investors will lose 1% for each 1% decline.

Reverse convertible

“This is a reverse convertible or a reverse convertible equivalent,” a market participant said.

“You have to be somewhat bullish on Citi or bullish enough so that you don’t expect the stock to fall in one year.

“It’s not an autocall. You get a coupon. There’s no downside protection so you would be long the stock if it falls.”

The issuer was able to offer a fixed coupon over a short period of time on a single underlying thanks to the recent increase in volatility, he added.

“The volatility of volatility is high,” he said, referring to the amplitude of volatility moves that have characterized the market over the past few days.

Surging volatility

The CBOE S&P Volatility index, which measures the implied volatility of options on the S&P 500 index, was at 13 on Tuesday. It jumped to 23 on Wednesday.

This uptick is not as high as in February when the VIX skyrocketed from 22 to 42 in one day. But it is the biggest surge since the market correction, which occurred then.

“The market conditions are all over the place. With such volatility, you can certainly generate higher coupons without contingency and on one asset,” he said.

“It is a typical reverse convertible even with that additional bonus,” he said referring to the step payment.

“You’re long the downside of the stock. You’re selling a put on Citi. The premium of your put is your 7.5% coupon.”

Time to unload

Dick Bove, bank analyst at Hilton Capital Management, was skeptical about the investment rationale, as he has turned bearish on the U.S. markets. This includes the financial sector.

“I’ve been telling clients to lighten up on bank stocks for a few weeks now,” he said.

The Financial Select Sector SPDR fund fell more than 3% on Wednesday amid a sharp sell-off that saw the Dow Jones industrial average shed 830 points, a 3.15% drop. Equity markets on Wednesday saw their worst decline since February.

The sell-off began last week as a result of a sharp and fast rise in Treasury yields, which investors had not anticipated.

Low profits

“People have been saying that rising interest rates will be good for banks’ profits. But wait a minute...” said Bove.

He observed the following: between the fourth quarter of 2015 when rates started to rise and the second quarter of 2018, which is the last period for which data are available, the Federal Funds rate has gone up 184 basis points. But net interest margins for banks have increased by only 26 bps.

“That should tell you something,” he said.

Another factor making Bove skeptical about bank stocks was the shift in the mix of banks’ holdings. Under government regulations, banks had to include more liquid and less risky assets on their balance sheet, which has considerably reduced yields.

Margin pressures ahead

“Banks are not paying anything on their clients’ savings accounts. With bond yields going up, bank customers are not going to stand for ridiculously low rates. That’s why more people are buying Treasury bills...three month, six month, and you can roll it without capital risk.

“The banks are going to have to pay up and it’s going to be tough since they compete heavily for loans.”

Meanwhile, the value of the financial instruments banks hold on their balance sheet will go down as rates continue to rise, he added.

“This is why investors are dumping bank stocks,” he said.

Entry point matters

Bove said the CIBC notes at least offered a 7.5% “cushion,” which is the guaranteed coupon.

“You have a 7.5% protection on the downside. So if the market is down 20%, at least you’re losing only 12.5%. But who wants to lose money?”

The notes will price at the end of the month.

“The critical variable is going to be the price of Citi when they initiate the trade. If the stock falls sharply for a couple of days before they strike the deal that would be good.

“But there is still too much risk in my opinion,” he said.

Bearish outlook

This analyst said he viewed the risk as global. His outlook for the U.S. stock market is negative.

“The U.S. is going to run this massive deficit for 10 years. Who’s going to buy the debt?

“In the last two years, traditional foreign buyers have been selling it. Social security funds don’t have the money.

“If U.S. investors have to buy it, they will need higher interest rates.

“And if American investors are moving their money into buying Treasuries, the market is not going to do well.

“This is why people should stay out of the market right now. Just keep your money out.”

BofA Merrill Lynch is the agent.

The notes will settle in November.

© 2015 Prospect News.
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