Citi’s $1.9 million CMS steepener range accrual on Dow, Stoxx Banks show high multiple

By Emma Trincal

New York, Jan. 22 – Citigroup Global Markets Holdings Inc.’s $1.9 million of callable fixed-to-floating rate CMS spread range accrual securities due Jan. 22, 2035 linked to the lesser performing of the Dow Jones industrial average and the Euro Stoxx Banks index provide a high probability of getting paid the maximum coupon amount despite the range accrual and the use of uncorrelated assets, sources said.

Two main factors behind their assessment is the high multiple applied to calculate the variable coupon and the current shape of the CMS curve.

The note pays a “teaser” rate of 9.3% on the first year, according to a 424B2 filing with the Securities and Exchange Commission.

After that, it will accrue at 50 times the spread of the 30-year Constant Maturity Swap rate minus the two-year CMS rate for each day each index closes at or above the accrual barrier, 60% of the initial index level, subject to a maximum of 9.3% and a floor of zero. Interest will be payable quarterly.

After one year, the notes will be callable at par on any interest payment date.

If the lesser-performing index finishes at or above its 60% barrier level, the payout at maturity will be par. Otherwise, investors will lose 1% for every 1% that the lesser-performing index declines from its initial level.

Steepener

“With 50 times the spread they’re trying to make sure you lock in the coupon,” said a market participant.

Investors are betting that the curve will steepen, which would increase the spread between the two rates.

“With the shift in the interest rate policy, the view is that the curve is not going to invert for a while. That perspective may change over time of course,” the market participant said.

One of the risks stated in the prospectus is that the variable coupon could decline to possibly zero if the short-term interest rate rises. The spread has historically been “highly sensitive” to the monetary policy of the Federal Reserve Board, the prospectus said. Since the Fed decided a year ago to pause its policy of raising short-term interest rates, such risk has receded.

“It’s not a bad play,” said the market participant.

“And we’re not starting at a very steep curve.”

Prior attempts to make bets on a steeper curve have not always paid off.

“On the secondary market you see a lot of busted trades. People bought those deals when the curve was much steeper. They sold at a discount. You can buy them at 70 cents on the dollar now,” he said.

Current spread

The spread between the 30-year CMS and the two-year is relatively tight from a historical standpoint.

The likelihood of getting the maximum payout is high, a fixed-income trader said.

“Right now, the spread is at 30 basis points. Fifty times that, that’s 15%. You immediately cap out at 9.3%. There’s such a high multiple, you are going to cap out very quickly,” he said.

A double bet

The structure of the notes has several moving parts. Each of them has to be assessed separately, he added.

“The investor first has to like the two underlying. That’s the range accrual. You have to know what’s in the trunk,” he said.

“The second thing is, they’ve got to be comfortable with where we are on the curve.”

This second aspect of the assessment could be positively impacted by the leverage factor.

“If we stay at a 30-bps spread, you get your cap. Even if the spread goes down to 20 bps, you’ll still be capped.

“If it’s at 10 bps, you get 50 times that, or 5%. It’s still a nice coupon,” he said.

“The curve is flat from a historical standpoint. It’s been like that for a couple of years.”

In 2010, the CMS spread was at 350 bps. In 2018, it was at 50 bps.

“We may still be flat for another couple of years. But with the high multiple, you’ll get that coupon,” he said.

European banks

Sources examined the pair of indexes used to satisfy the accrual condition.

Combining the Dow Jones industrial average with a large-cap sector index in Europe was unusual, they noted.

The broader Euro Stoxx 50 index is much more common, they said.

“I know banks have been pushing the Euro Stoxx Banks index. It seems like European bank stocks are on the rise,” said the market participant.

“They use the Euro Stoxx Banks component because it seems like it’s the only one that has volatility. If it was the Euro Stoxx 50 you couldn’t get near those terms,” the trader said.

Correlation, multiple

One element of risk was the low correlation between the two underlying indexes. The 60% barrier applied to the worst-performing underlying could, if breached, limit the amount of coupon paid or cause investors to lose principal at maturity.

“People want the high multiple,” the market participant said.

“You wouldn’t get 50 times the spread with two correlated assets. People recognize that.”

For the market participant, the Euro Stoxx Banks index was well-positioned for a continued rally.

“It’s not a bad index. Banks like BNP, Credit Agricole are doing well. It’s a sector that’s been beaten down but now looks rosier,” he said.

“If you have a tactical mindset, this underlying index makes sense.”

Risk

Other factors lowering the overall risk were the barrier level and the issuer call.

“40% is a solid protection. It’s a long tenor but with the call, it’s not to be held for 15 years,” he said.

“If you’re interested in range accrual products it tells a good story.

“You’ve got a lot of protection. The teaser rate is high. The multiple is very high. For those who like range accrual notes – and some people do – it does offer an interesting payoff.”

The trader agreed.

“It’s what’s out there: steepeners with high multiples, 60% barriers, two or three underlying. Nothing out of the ordinary but it’s still a nice deal. It’s a good offering,” the trader said.

Citigroup Inc. is the guarantor.

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 17327TC95) settled on Tuesday.

The fee is 4.85%.

© 2015 Prospect News.
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