Citi’s $1.65 million callable range accrual notes on indexes, CMS rates offer exotic payoff

By Emma Trincal

New York, Jan. 20 – Citigroup Global Markets Holdings Inc.’s $1.65 million of callable range accrual securities due Jan. 15, 2041 contingent on the 30-year Constant Maturity Swap rate, the two-year Constant Maturity Swap rate and the least performing of the Euro Stoxx Banks index, the Russell 2000 index and the S&P 500 index may not appeal to retail investors due to the various “moving parts” of the structure, a market participant said.

Interest will accrue at a contingent rate of 7% 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 60% barrier level, in which case investors will be fully exposed to the decline of the worst performing index.

Many layers

“I don’t like it at all. You’re adding unnecessary risk to a product,” said a market participant.

“We see a lot of steepeners on the secondary market. But they’re simple in comparison. It’s just on the CMS spread. And they can trade 60 cents on the dollar, not at par.

“The range accrual component with the equity, some people like it. But it just complicates things for investors.

“I would have a difficult time finding a client for it, especially with a 7% yield. There is not even a teaser rate, not that it makes such a difference.

“Right now, I can price a two-year, the single underlying on the Russell, 25% barrier and get 8% on it.”

The notes had too many “layers,” he said.

“You have the worst-of... the fixed-income accrual component...the range accrual equity component. I don’t see that for a retail investor. It’s just too complicated.”

One rate

Using only one underlying rate would make the product easier to understand, he noted.

“You could have something tied to the 10-year CMS alone. I still don’t think people would love it but at least it’s a little bit more straightforward. You can explain it.”

The products he was referring to are usually fixed-to-floating rate notes linked to one CMS rate (either the two-year or the 10-year). The variable rate is the CMS rate itself subject to a cap and a floor.

“If we want to grow this market, simplifying the payoffs and promoting a certain level of education are the most important things to do,” he said.

Typical steepeners

Traditional steepeners only reference the spread between the long- and short-term interest rates.

They are much more abundant in the secondary market than as new issues, bond traders said.

Steepeners typically repay the full principal at maturity; the spread can be levered; the floating rate may come after a short period of fixed rate, which may last one or two years.

“This is not giving you 15 times the spread; your principal is at risk after 20 years and you have this accrual component with the worst-of on the equity side,” the market participant said.

“If I was buying that note at a discount, maybe I would see it differently. But that’s not the case.”

Secondaries

Bond traders on the secondary market see renewed interest for classic steepeners.

“CMS spreads were flat for the last couple of years. They’re very steep now. When your coupon is tied to CMS spreads it looks very attractive compared to yields seen in the corporate or muni bond market,” said one of them.

“Equity markets took the spotlight, but as the curve becomes more positively sloped, you can pick up higher yields.”

Long-term rates

Treasury rates gained ground recently. For a growing number of investors, rates are likely to rise due to increased government spending, which, according to some, may bring back inflation and higher long-term rates.

A financial adviser with a bearish outlook on stocks disagreed with this outlook, saying he does not expect long-term rates to rise anytime soon.

“Treasuries, a safe-haven, are not popular. People prefer to buy risky, overextended growth stocks. This is not going to last forever,” this adviser said.

“When equity markets drop, people will bid on Treasuries in a flight to quality.”

If that’s the case, steepeners may prove to be a risky bet, he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The notes settled on Jan. 15.

The Cusip number is 17328YBD5.

The fee is 5%.

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