Citi's $38.46 million leveraged CMS curve-linked notes drew top bid for high rate, curve bet

By Emma Trincal

New York, Nov. 20 - Citigroup Inc.'s $38.46 million issue of leveraged callable CMS curve-linked notes due Nov. 15, 2028 linked to the 30-year Constant Maturity Swap rate and the five-year Constant Maturity Swap rate was last week's largest deal, according to data compiled by Prospect News. Investors bid on the issue in an effort to capture yield, betting on a steeper curve.

The interest rate is 10% for the first year, according to a 424B2 filing with the Securities and Exchange Commission.

Beginning Nov. 15, 2014, the interest rate will float and be four times the spread of the 30-year CMS rate over the five-year CMS rate, subject to a minimum interest rate of zero and a maximum interest rate of 10% per year. Interest is payable quarterly.

The payout at maturity will be par.

The notes become callable beginning Nov. 15, 2015 on any interest payment date.

"Yes, I've seen the deal," a sellsider said.

"Morgan Stanley between their internal and external distribution demonstrated the ability to gather notional."

Morgan Stanley Smith Barney LLC was the dealer, according to the filing.

Yield search

Investors bought the product in an effort to capture a high interest rate on the first year, a market participant said.

"I guess it's interesting," he said.

"We're seeing these types of trades a lot. You get 10% for the first year. On year two, you get the formula. ... The reason they're doing well is that they're paying you a high guaranteed fixed rate on the first year. After that, people are betting that the spread is not going to tighten that drastically to the point of an inverted curve," he said.

He gave an example.

"Even if your spread is only 50 basis points, you get 2%. Two percent is better than what they're earning right now. You get 10% on the first year, then 2% and maybe you get called right away. It's 12% over two years. I don't know a lot of investors who would complain about 6% per annum on a principal-protected note," this market participant said.

He noted that the yield curve "so far has been steepening."

The five-year CMS rate is now at 142 basis points, and the 30-year rate is at 368 bps, which generates a spread of 226 bps, he said. A year ago, the same spread was tighter at 177 bps, he noted.

"So yes, we got steeper. But the question is for how long?"

Fed risk

In his view, a lot of the risk is political.

"The reality is we are in a unique environment. Interest rates are being manipulated by the Fed," he said.

"We don't know much about the Fed direction, where they're heading to. It's like going to the Moon and bringing an oxygen tank.

"This monetary policy is an experimentation that has never been done before to this extent of time.

"When the Fed stops manipulating the market, you can't rule out an adverse reaction with the curve inverting. It's possible."

Short-term rates, for instance, could be moving up faster than long-term interest rates as the Fed could continue funding what represents its "highest liabilities" on the longer end of the curve, he explained.

"While those deals look attractive, you have to think of what happens with the curve after the first year. My name is not Ben Bernanke, and I find it very tricky to make long-term bets on a curve when you have a market that's being manipulated by the Fed," he said.

Citigroup Global Markets Inc. is the underwriter.

The notes (Cusip: 1730T0A82) priced Nov. 12.

The fee was 3.5%.

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