Citi’s callable CMS spread range accrual notes on indexes show bet on growth for income play

By Emma Trincal

New York, Oct. 1 – Citigroup Global Markets Holdings Inc.’s $665,000 callable fixed-to-floating CMS spread range accrual securities due Sept. 20, 2041 linked to the least performing of the Euro Stoxx Banks index, the S&P 500 index and the Nasdaq-100 index offer an attractive source of income worth considering despite its relatively complex structure and long-term horizon, advisers said.

The interest rate is 9% for the first two years, payable quarterly. After that, the coupon rate is 25 times the 30-year Constant Maturity Swap rate minus the two-year Constant Maturity Swap rate for each day all three indexes close above 60% of their initial levels, subject to a maximum rate of 9% and a floor of zero, according to a 424B2 filing with the Securities and Exchange Commission.

The notes will be callable at par on any quarterly redemption date after two years.

The payout at maturity will be par if each index closes above 60% of its initial level.

Otherwise, investors will be fully exposed to the losses of the worst-performing index.

High yield

“In today’s fixed-income space 9% is a pretty good coupon. To achieve something equivalent in high yield, you’d have to take much more risk,” a financial adviser said.

The structure, also known as “steepener,” is a bet on a wider yield curve since the widening of the spread between the two maturity points of the curve increases the size of the floating rate.

However, unlike many of the current fixed-to-floater steepeners tied to a CMS spread, this note does not offer full principal protection, he noted. But he considered the risk as limited.

“I doubt you’re going to take a loss 20 years from now with that 40% protection. That’s not even a consideration,” he said.

Range accrual

The range accrual feature adds another level of risk, this time at the income level.

The floating rate is 25 times the CMS spread in a range of 0% to 9%. But the actual rate will be limited to the accrual days on which the three indexes are at or above the 60% barrier.

As an example, the prospectus assumed a 2% CMS spread. After leverage, the rate is capped at 9% per annum. If during one quarter, the three underlying equity indexes meet the accrual conditions two-thirds of the time, or 60 days out of 90, the floating rate will then be 6% per annum.

The range accrual, the principal-at-risk and the cap allowed the issuer to provide a number of attractive features, this adviser said. Among those, he cited the two-year teaser rate at 9%, the 25-leverage multiple, a relatively high cap of 9% per year and the deep barrier.

Consistent payout

Unlike a coupon barrier in a Phoenix autocallable, which will determine whether the full coupon is paid or not on a given observation date, the range accrual formula may only reduce the size of the coupon, not skip its payment.

“It won’t accrue as much. So, you may get less. But most of the time you should get paid something,” he said.

Another positive factor for income investors was the leverage.

“You have this hefty 25 times. The spread doesn’t even need to be that steep,” he said.

“Your chances of collecting the coupon or some percentage of it are pretty high.”

Perhaps just as attractive was the 9% fixed rate, which is paid for the first two years regardless of market conditions.

70’s memories

One possible risk was inflation, especially accelerating inflation pushing rates higher at a fast clip.

“That’s the real issue here. If rates jump, if we get into a 1970’s-like inflation, this 9% coupon won’t look as attractive,” he said.

“But in today’s low interest rate environment it’s really great.

“The question really is: will we get back to the 1970’s style of inflation or will the Fed figure out a way to avoid it?”

Solid bet

Jeff Pietsch, founder of Eastsound Capital Advisors, also downplayed the downside risk at maturity.

“I wouldn’t worry about it with a 60% barrier and over such a long period of time. How often can you be down more than 40% over a 20-year period? What’s the probability? I think you’re not much at risk,” he said. The bet on a steeper curve was a reasonable one, he added.

“Short-term rates are poised to rise over the next two years. The Fed has been clear about it. I wouldn’t bet against the Fed,” he said.

A monetary policy consisting of raising short-term interest rates is one of the risks associated with the notes since CMS spreads historically tend to fall when short-term interest rates rise. But one of the notes’ features may offset some of that risk, he said.

“Even with short-term rates likely to rise soon, you’re somewhat covered by the two-year teaser rate.”

On the long end of the curve, Pietsch’s economic outlook supported the view of a widening CMS spread.

“Long-term interest rates should rise, and the curve steepen because the economy is going to grow and to a certain degree because of inflation.

“Betting on economic growth over the long run is a good bet.

“I wouldn’t bet against the U.S. economy,” he said.

Taming inflation

Inflation, unless extreme, might work in favor of the noteholders.

“We are seeing some signs of inflation. This note could offer a great inflation hedge for a modest inflation scenario.

“If we have hyperinflation, the 9% rate may be limiting. This would not be a positive scenario. But it’s also not a very likely scenario. I wouldn’t bet on it.”

Finally, the curve may get steeper by virtue of market cycles.

“We’ve had a record compression between the short and the long end of the curve for a long time. This trend will revert,” he said.

Income play

For income investors, the notes offered an interesting opportunity, he said.

“I see this note as part of an income strategy, and it’s an interesting one,” he said.

“The coupon is better than the TIPs.

“Even if the curve steepening isn’t huge, you have a nice levered up protection against that. The 25x really helps.”

The equity components of the structure had more of an impact on cash flow than capital.

“Over the very long term, your capital isn’t really at risk,” he said.

“Twenty years is a very long time. You may have more counterparty risk than you have market risk.”

Finally, the issuer call introduced some uncertainty without making the product lose its appeal. At least the 9% coupon is guaranteed on the first year, he said.

“It’s a little bit complicated but I like it,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Sept. 20.

The Cusip number is 17329QSV3.

The fee is 5%.

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