Citi prices $20 million of capital-at-risk notes for short-term bet on yield curve inversion

By Emma Trincal

New York, Jan. 24 – Citigroup Global Markets Holdings Inc.’s $20 million of 0% principal-at-risk securities due April 12, 2024 linked to the 10-year U.S. dollar ICE swap rate minus the two-year U.S. dollar ICE swap rate surprised some market participants familiar with rate-linked products. The principal-at-risk, the short maturity and the embedded contrarian view on the yield curve were unusual features without mentioning what they perceived as a highly risky trade, in contrast with most rate products.

Risk-return

Investors in the short-term note earn a fixed return of 16.42% if at maturity the spread finishes lower than its strike level of minus 0.174%, according to a 424B2 filing with the Securities and Exchange Commission.

This favorable outcome occurs if the yield curve remains as inverted as its strike or becomes more inverted.

As such, buying the note reflects the expectation that long-term rates will be lower than short-term rates in three months.

The adverse and opposite outcome is if the spread finishes greater than the strike, meaning that within the period, the curve has become steeper. In that scenario, investors may lose up to 83.58% of their principal, keeping 16.42% as their minimum payment at maturity.

Not easy reading

“It’s a complex structure. It’s also a contrarian play,” said a structurer.

The filing defined the payout as follows:

If the value of the 10-year U.S. dollar ICE swap rate minus the two-year U.S. dollar ICE swap rate on April 10, 2024 is less than or equal to negative 0.174%, at maturity investors will receive $1,164.20 per $1,000 note.

Otherwise, investors will receive $1,164.20 minus [$1,000 × the product of (a) (1/0.5%) times (b) (the SOFR CMS spread on the valuation date minus negative 0.174%)], subject to the minimum payment of $164.20 per $1,000 principal amount.

“Bottom line: as long as the spread on the yield curve stays negative, you get paid,” he said.

March meeting

He explained why the bet was contrarian.

“The Fed is supposed to lower interest rates this year. The market expects a 25 basis points cut as soon as March,” he said.

“That’s very close to the maturity date. If they do that, the two-year rate will fall faster than the 10-year, making the curve less inverted, which is not what you want. You want the opposite,” he said.

The maximum loss of 83.58% could happen if the spread at maturity finished greater than 0.3260% according to the prospectus.

High risk

“The potential return is huge. 16% in three months is a huge return. But the note is not secured. You can also lose more than 80%,” this structurer said.

Both the term and risk associated with the structure were highly unusual for these types of notes.

“We really don’t see that many principal at risk rate products especially over such a short timeframe,” he said.

For this structurer the notes were “very risky.”

“If the Fed lowers rates in March as the futures market anticipates, the spread can jump and go up pretty fast,” he said.

The 23-day period between the March 20 FOMC announcement and maturity date may be too short to reestablish a flat or negative yield curve, he added.

“It’s unlikely that you would hit the maximum loss of 83%. But the curve could be slightly positive,” he said.

Using one of the hypothetical examples in the filing, an increase of only 0.05% of the spread would translate into a 28.38% loss of principal.

“This is not a deal for retail investors. It is far too risky,” he said.

Lottery

A bond trader said he did not like the deal.

“This is terrible, horrible. It’s much too complicated and it brings nothing positive to the holder,” he said.

“You’re taking much more risk than you can get rewarded for.”

For this trader, the curve is going to steepen, making the trade even less attractive.

“The Fed is going to cut rates. The curve is going to be positively sloped, which is exactly the worst thing if you hold those notes.

“You’re going to lose money and a lot of money,” the trader said.

For this trader, the economy, while not officially in a recession, needs some easing on the part of the Fed.

“They have to cut. The economy needs a stimulus. We’re running into a recession.

“It’s a bet against common sense. It’s like playing the lottery. You are almost certain to lose,” he said.

As a fixed-income market participant, he expressed surprise at the risky nature of the trade.

“You could lose almost all of your money in a very short time. It’s unheard of. I’ve never seen something like that unless you’re in the equity space,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settle on Jan. 18.

The Cusip number is 17291TVS4.

The fee is 0%.

© 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.