Citigroup’s fixed-to-floaters on leveraged CMS spread offer attractive tenor for tough bet

By Emma Trincal

New York, April 4 – Citigroup Global Markets Holdings Inc.’s fixed-to-floating notes due April 18, 2023 linked to the leveraged difference between the 30-year Constant Maturity Swap rate and the two-year Constant Maturity Swap rate present the characteristics of a likely short-term bet with a five-year tenor and a call after one year, sources said. Getting the bet right however when it comes to predicting the shape of the yield curve is not easy, they said.

Interest will be 5% until April 18, 2019. After that, the rate will be equal to 18.5 times the spread of the 30-year CMS rate over the two-year CMS rate, subject to a maximum rate of 10%. Interest will be payable quarterly and cannot be less than zero, according to a 424B2 filing with the Securities and Exchange Commission.

The payout at maturity will be par.

The notes are callable quarterly in whole at par beginning April 18, 2019.

Yield curve

“This deal makes sense. The curve right now is so flat. The view is: it’s so flat, it can only steepen,” said a market participant.

The 30-year CMS rate is 2.84% and the two-year, 2.59%, which gives a 25 basis points spread.

“If you apply the formula, it gives you a current rate of 4.62%,” he said.

“That’s very close to the first-year teaser of 5%.”

He calculated the variable rate based on today’s spread by multiplying 25 bps by the 18.5 leverage factor.

Many of the economic factors that may impact CMS rates and the spread between CMS rates of different maturities, can vary, sometimes in opposite ways making predictions of future spreads nearly impossible.

“Look at a bear market. You can argue either way. Risk off, same thing: rates could go up or down.

“People could put money in the two-year or they could put money in the 30-year.

“It’s not about interest rates. It’s about spreads between long and short-term rates,” he said.

Short, callable

This market participant said that the product was attractive for its short tenor.

“A lot of the times, those deals pay a teaser rate for the first year or two but that’s on a 10-year, or even 20-year note. This one is only five-year, which is much better,” he said.

The call feature after one year was likely to be activated, he said.

“This call is how they can offer the 5% on year one. If rates go up a lot and the spread widens, they’ll call the deal. It allows them to get out if the curve becomes too steep.”

Risk

This would not be the worst scenario for investors. A riskier outcome of course would be to see the curve remaining flat or even becoming inverted.

“You could get your 5% for five years if the spread narrows to zero. Yes, you got 5% on the first year, but you might be stuck with a zero coupon for the next four years,” he said.

In comparison, investing in the four-year CMS, which currently yields 2.5%, would give investors a 10% return.

“You could be stuck at 5% for five years while you could have earned twice that in four.

“There is no sure game. That’s the risk you’re taking,” he said.

Market turmoil

“Betting on the future shape of the yield curve is very difficult,” said Paul Weisbruch, vice-president options sales and trading at Street One Financial.

On the short end of the curve, interest rates are expected to rise. But the market environment has become more uncertain.

“The Fed has moved into a tightening bias, but how much and how fast are they going to hike rates? Two months ago, people were worried about inflation. The economy was strong, the market very bullish. People expected more rate hikes. All of a sudden, we have volatility surging in the equity markets and the trade war headlines suggest the economy may suffer.

“Central Banks don’t want equities to go through a free fall.”

Trade wars

Right now, long-term treasuries are not responding much to the shock seen in the stock market, which is reacting to tariffs announced between the U.S. and China.

But if volatility continues to pick up, the flight to safety may lead yields on the 10-year and the 30-year bond to drop.

“There is absolutely no way you can guess right now with several Fed meetings to go the future shape of the yield curve,” said Weisbruch.

“A lot of it will depend on whether this trade war rhetoric is real or not. But it’s certainly not helping anyone. If it’s real, it will hurt everybody. If it’s not I can see some other corners of the market being shaken.”

The notes will be guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the agent.

The notes are expected to price on April 16 and settle two business days after the pricing date.

The Cusip number is 17324CTV8.

© 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.