Citi’s $2 million callable CMS spread notes boost yield with daily range accrual, worst-of

By Emma Trincal

New York, Aug. 27 – Citigroup Global Markets Holdings Inc.’s $2 million of callable CMS spread and index-linked range accrual notes due Aug. 26, 2041 linked to the Euro Stoxx Banks index and the Nasdaq-100 index are a more elaborated steepener as the structure combines a progressively rising leverage factor applied to the spread and a range accrual observation of the worst-of performance of two equity indexes.

Interest will be fixed at 10% for the first year, according to a 424B2 filing with the Securities and Exchange Commission.

After that, it will accrue at an annual rate equal to the interest factor, starting at the product of 13 times the spread of the 30-year Constant Maturity Swap rate minus the two-year Constant Maturity Swap rate on the related observation date for each day that the closing level of each underlying index on that day is greater than or equal to its accrual barrier level, 65% of its initial level.

The leverage factor by which the spread is multiplied increases after the 10th year of the notes. For the 11th through the 13th year of the notes, the adjustment factor increases to 14. For the 14th and 15th years, the spread is multiplied by 15, and increases again to 16 for the remaining life of the notes. All interest rates are subject to a maximum interest rate of 13.6% and a minimum interest factor of 0%.

Interest will be paid quarterly after the first year based on the calculated interest rate detailed above multiplied by the number of days each quarter that each index has closed above 65% of its initial level divided by the number of days in the interest accrual period.

The payout at maturity will be par if each index finishes above 65% of its initial level.

Otherwise, investors will be fully exposed to the decline of the least performing index.

Daily accrual

“The structure is average but there are a lot of moving parts to keep track of for 20 years,” said a rates-linked notes broker.

“The daily range accrual for the equity part is good for investors. If it’s observed from the beginning to the end of a quarter, you could miss the conditions. But when you observe the barrier daily and it accrues for each day the index is above the barrier, at least you should get something.

“While it’s not unique, I think what gives a lot of value to this deal is the fact that the multiplier is stepping up.”

Correlation

The use of equity indexes through a range accrual feature and worst-of observation allowed the issuer to increase the size of the coupon, he noted.

“The Euro Stoxx Banks is more volatile than the Euro Stoxx because it’s a sector play, not a broad index. The Euro Stoxx doesn’t’ seem to have enough vol. So that’s why they picked the Banks one,” he said.

“Then you combine a European index with a U.S. index; you’re picking up some yield by playing with the lower correlation.

“One good thing: a lot of those products have three indices. Having only two is a good thing.”

Yield enhancement

Investors in the notes are betting that the yield curve will steepen.

The current spread between the 30-year CMS rate and the two-year CMS rate is 135 basis points.

Over the past 10 years, the high was 344 bps in November 2013 and the low, 5 bps in August 2019.

The average for the past decade was 144 bps.

“We’ve widened out so much from the lows. Now we’re close to the average,” he said.

Advisers buy those notes despite their complexity, he said.

“It’s part of their bond portfolio.

“You really do get a higher return because you have the leverage and you’re using the spread.

“With this one, you’re also getting a 13.6% cap, which is quite good,” he said.

Fed tapering

The notes settled just ahead of the Federal Reserve’s monetary policy symposium in Jackson Hole, Wyo.

Fed chairman Jerome Powell reiterated that the central bank could begin tapering its bond purchases later this year without giving a date.

The bond market did not really react to the speech. Stocks rallied, hitting fresh record highs.

“This note is not a taper play,” the broker said.

“You can’t make a taper play when you buy a 20-year note even though I don’t think people who buy those callable notes are interested in holding it for 20 years.”

The notes are callable at par quarterly after one year, according to the prospectus.

“The call is how you pick up that risk premium. That plus the risk of one of two indices hitting the barrier,” he said.

The issuer will call the notes when the spread is too high, he said.

“Citi doesn’t intend to pay a high coupon. They won’t pay the cap. The issuer wants the spread to flatten so they can pay less interest.

“Investors though, when looking at those things, they look at the cap.”

Market risk

A bond trader criticized the choice of the equity underlying.

“I don’t like the indices. It’s not that I don’t like having equity in a steepener. I just don’t think they picked the right indices,” he said.

“The Nasdaq is at all-time highs. It’s due for a correction. The Euro Banks one has never been popular, even the Euro Stoxx is not popular.”

Good terms

But the deal itself was not all bad.

“The structure is a good structure.

“What’s appealing is the leverage. It’s a good level and I like the step up.

“The range accrual in itself is not a bad thing. That’s how you get the real kick on the bond. There is more risk and so you can boost the yield.

“The 30 minus 2 is a good part of the curve. It will go close to 200 in a year or so.

“The cap is a big cap. It might be called or not,” he said.

Swap factor

For this bond trader, more than one factor determines whether the issuer will call the notes or not.

“People always think that the issuer is going to call if they have to pay a high coupon. But it’s all about the swap,” he said.

“If they can redo the swap profitably, they will pay the coupon even if it’s the cap.

“It has nothing to do with how high the coupon is. They’re not paying out of pocket.”

The issuer merely exchanges the funding rate for a swap on the CMS curve, he explained.

“They change a fixed rate for a floater. That’s how they pay the coupon.

“So, if they can do the swap, they’ll pay the coupon.

“If they can’t, they’ll call the notes,” he said.

The most likely sell-off

Over time, when the Fed really begins to reduce its monthly bond purchases, the impact should be mostly felt in the stock market, this bond trader said.

“Each time the Fed talks about tapering, Wall Street expects they’ll be hiking rates as well. But that’s not necessarily the case at all,” he said.

“Tapering just means they’ll buy less bonds in the market. That said, interest rates on the intermediate, longer term may rise,” he said.

“But the Fed will monitor it. It’s only if the economy and inflation heat up that they will raise interest rates.

“They’re tapering because they just want to see what’s happening.

“Personally, I think stocks will be hit harder than bonds when they taper.

“This is why with a note like this, I’m more concerned about things linked to the stock market. If it was linked to the S&P and Russell, I would like it better.

Citigroup Inc. is the guarantor.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Aug. 25.

The Cusip number is 17329QH94.

The fee is 5%.

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