Citi’s $25.38 million leveraged CMS spread notes signal continued interest for steepeners

By Emma Trincal

New York, May 26 – Market participants spotted a good-sized steepener deal last week, which seems to confirm a growing interest for those unusual rates products.

Citigroup Global Markets Holdings Inc. priced $25.38 million of callable fixed-to-floating rate leveraged CMS spread notes due May 21, 2031, according to a 424B2 filing with the Securities and Exchange Commission.

The interest rate is 4% for the first year. After that, it will accrue at a rate of 3.25 times the 30-year Constant Maturity Swap rate minus the five-year CMS rate, subject to a maximum of 8% and a floor of 1%. Interest will be payable quarterly.

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

The payout at maturity will be par.

Growing interest

This was the largest fixed-to-floating CMS steepener deal so far this year although GS Finance Corp. priced a similar product for $25 million in March, according to the data.

Steepeners are bets on a widening spread between the longer and shorter part of the yield curve.

Those products have been popular but mostly as secondaries, traders said. Yet recently, an increasing number of new issues have been identified.

Fifty-nine new issues of CMS steepeners have priced this year through May 19 for a total of $315 million, according to data compiled by Prospect News.

Last year’s notional during the same period was only $83 million issued in 26 offerings.

Institutional product

“I’m not surprised to see more steepeners in this market. The fear of inflation has caused longer rates to rise while short-term rates have remained low. So, the strategy makes sense,” said Samuel Rosenberg, managing partner at Lutetia Capital.

While the number of CMS spread notes has increased, investors remain for the most part unfamiliar with the underlying and the structure, he noted.

“The main problem with these products is that they’re often longer dated. It makes them well-suited for institutions, not so much for retail investors,” he said.

“Institutional investors have longer duration portfolios and longer liabilities. For them, 10-year or 20-year is not a stretch. But for individuals, a 10-year maturity is a long time.”

Tough times recently

The market was not always so attractive for those betting on a steeper yield curve, he noted.

“A few years back, you had a lot of steepeners. But people got burned when the curve flattened. The mark-to-market were down. Suddenly, a note you purchased at 100 was worth 82.85. So, you put 100 today and you’re stuck for 10 years. You may have your principal guaranteed but it’s a huge opportunity cost. And while you’re holding it, you’re seeing people doubling their money with stocks. Investors get frustrated. They don’t like those longer-dated maturities.”

Fees

When it comes to yield, autocallables on equity compete for investors’ attention.

“The 1% floor is good. But it’s not much when you can make several times that in three or six months,” he said.

“So yes, market conditions are favorable for steepeners right now. But retail investors are not necessarily piling in.”

Brokers’ incentive to sell those products is also a limitation. The fee for this deal is 1%, according to the prospectus.

“For a broker, 1% for a 10-year product isn’t much when you can make 1% in six months,” he said.

Floor incentive

A bond trader said the notes offered decent terms.

“The value here is the 1% floor. Most issues that come out don’t have a floor,” this trader said.

“But of course, you give up something because the floor is going to cost a lot of money.

“Without the 1% floor, you can get steepeners with much greater leverage and better terms.”

He said he is seeing right now 10-year steepeners with a 7% teaser rate over one year paying six times the difference between the 30-year CMS rate minus the five-year CMS rate minus 25 basis points with a floor of 0% and a cap of 10%.

“What Citi is showing is not bad though. The lower leverage makes the floor more important to have,” he said.

Back on the horse

“I’m not going to tell you what to buy. For some people, having a guaranteed rate over the term is extremely attractive.

“Others prefer to get paid a high coupon upfront on the first year. Personally, I prefer the higher teaser rate. But it doesn’t matter what I prefer. What’s important is to create an issue for you that will fit your parameters.”

Investors also have to overcome past negative experiences in a space they should try to be more familiar with.

“There’s been a two-year period when the curve was flat. So, it was two years of bad luck,” he said.

“I never understood why investors in the bond market can’t handle a period of volatility while the stock market can be down hundreds of times.

“Some people who bought those notes had a hard time when the curve flattened. They’re not looking to forgive and forget. They’re just out. But that’s a mistake.

“When somebody dies you look at the long-term perspective. You celebrate their life, not the two days they screwed up.”

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Friday.

The Cusip number is 17329FL93.

© 2015 Prospect News.
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