Citi’s $2.5 million callable range accrual notes on indexes, CMS rates offer exotic steepener

By Emma Trincal

New York, Aug. 19 – Citigroup Global Markets Holdings Inc.’s $2.5 million of callable range accrual securities due Aug. 14, 2035 contingent on the 30-year Constant Maturity Swap rate, the two-year Constant Maturity Swap rate and the least performing of the S&P 500 index, the Russell 2000 index and the Dow Jones industrial average offer long-term income based on a range accrual structure combining interest rate and equity indexes underlying. Investors are betting that the yield curve will steepen or stay steep over time while discounting the odds of a lengthy equity bear market.

Interest will accrue at an initial rate of 8% for each day that the spread of the 30-year Constant Maturity Swap rate over the two-year Constant Maturity Swap rate is at least zero and each index closes at or above the 60% accrual barrier, payable quarterly, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be callable at par on any quarterly redemption date after one year.

The payout at maturity will be par unless any index finishes below its final barrier level, 60% of its initial level, in which case investors will be fully exposed to the loss of the least-performing index.

Higher long-term rates

“Betting on a steeper yield curve makes sense,” said Edward Moya, senior market analyst at Oanda, a multi-asset brokerage firm.

“There are tons of supply being issued and more pressure is building up. Demand is not as strong, so it’s pushing expected yields higher,” he said.

Market expectations about inflation may also be at a turning point.

“Last week the [Producer Price index] and the [Consumer Price index] have come higher. While we’re still nowhere near inflation this year, it does show things could heat up a little bit in the future as soon as this economy is on sound footing again,” he added.

In the past two weeks, the 30-year CMS rate has increased to 1.40% from 1.20% as a result of those unanticipated inflation figures.

“Expectations that interest rates will continue to be low for an extended amount of time could change, especially once the recovery will accelerate in 2021.

“This recent move in Treasuries shows that volatility in the space is going to remain high.

“As people become optimistic again regarding the economy and as we move toward a much more normal market, more signs will support the idea behind a steeper curve.”

Not mainstream

A structurer of equity-linked derivatives said range accruals such as this deal with a mix of rates and equity components makes for a not so common product.

“This is not a deal for individual investors. Rates-linked structures are useful for people who hedge Treasuries for corporations and institutions. That’s the type of reference asset they use, but not so much in the wealth space.”

Investors in the private wealth arena are more inclined to buy equity-linked notes as new issues, he added.

“I’m not sure who you go after when you’re marketing this kind of product. Volatility in fixed income was really high. It’s dampening now. But when you add equity conditions to the spread condition, it starts to become really hard to explain in the wealth space.”

Some features in the structure were likely to be criticized by individual investors.

“You have a 15-year maturity. Plus, the call is at the issuer discretion. That means the notes will be called when it’s good for the issuer. You could be stuck with a 15-year paper,” he said.

In addition, very few retail investors have a view on the steepening of the yield curve.

“It can happen. Some people may make bets on the relationship between short- and long-term rates. But I haven’t seen it very often. And you’re also benchmarking an equity portfolio.”

Risk

Part of the volatility of the asset class is due to the challenge of interpreting what the Federal Reserve will do next on the short end of the curve and how both the Fed and the market will impact long-term rates.

“The Fed has been pretty transparent about keeping short-term low. The shape on the long end of the curve is harder to predict,” he said.

“The Fed controls it via asset purchases. But a lot of factors can influence these actions, like people’s willingness to hold long-term Treasury bonds, their concerns about the sustainability of the U.S. debt and their perception of rising inflation.

“It’s harder to control the long end of the curve, which makes those steepener bets somewhat hazardous in my opinion.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Aug. 14.

The Cusip number is 17328W7K8.

The fee is 5%.

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