Citi’s fixed-to-floating CMS spread range accrual on indexes offer bond alternative, adviser says

By Emma Trincal

New York, June 4 – Citigroup Global Markets Holdings Inc.’s $6.18 million of callable fixed-to-floating rate CMS spread range accrual securities due May 29, 2035 linked to the least performing of the S&P 500 index, the Russell 2000 index and the Dow Jones industrial average provide a good opportunity for income, but the deal is not for everyone given its complexity and long tenor, advisers said.

The interest rate is 8% for the first four years, according to a 424B2 filing with the Securities and Exchange Commission.

After that, it will accrue at a rate of 8% for each day the 30-year Constant Maturity Swap rate minus the two-year CMS rate and each index closes at or above the accrual barrier, 60% of the initial index level. Interest will be payable monthly.

The notes will be callable at par on any quarterly interest payment date after one year.

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

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

Curve twist

“8% a year for four years is pretty neat,” said Steve Doucette, financial adviser at Proctor Financial.

After that initial period, the payout will depend on how often the worst of the three indexes will remain above the 60% barrier and how many days the yield curve will stay positive, he noted.

“Problem with that: I have no idea what the shape of the curve will be like four years from now,” he said.

The risk of losing principal, which is only based on the three equity indexes, was not his main focus.

“Your risk is to get paid less than 8% if the accrual formula doesn’t work out. Theoretically you could get paid 0%,” he said.

“The risk at losing principal at maturity is not really a concern.

“I can’t imagine 15 years from now you would be down 40% from today’s levels.

“But how often are you going to get paid after four years, that’s the real issue. It all depends on how often the yield curve is going to be inverted. I have no idea.”

30-2 spread

The 30-year/2-year CMS spread has not been negative very often, according to a chart from the Federal Reserve Bank of St. Louis.

During the dot.com bubble, the curve inverted from July to December of 2000. The inversion also occurred a few days in both February 2006 and later on in the fall.

Looking back further however revealed stretches of time when the CMS curve remained inverted much longer.

The spread was negative between November 1988 and August 1989. The longest period covered August 1980 through January 1982 preceded by a period from September 1978 through May 1980.

“The 1980’s were ugly, and it’s not clear if we’ll have a similar picture.

“You might lose your coupon anywhere between nine and 15 months over a 15-year period. Maybe. It’s really hard to tell,” he said.

Bond replacement

The range accrual formula offers advantages over a barrier, he noted. It merely reduces the amount of payment if fewer days of accrual are computed. In comparison, a barrier event is a binary situation which determines whether or not the coupon is collected.

“It seems like a reasonable fixed-income alternative,” he said.

“You capture an 8% coupon for the first four years.

“After that, you may not collect all the time. But there are good chances that you will collect most of the time.

“Of course, you can get called after a year. That’s the risk you run on any of those calls.

“But where else are you going to collect 8% other than with high-yields in this environment?”

Doucette in conclusion said he liked the notes.

“It’s more complicated than it needs to be. But you have a good chance to collect the coupon all the way through until it’s called. Then you run the reinvestment risk, but that’s the tradeoff,” he said.

Call risk, moving parts

Matt Medeiros, president, and chief executive of the Institute for Wealth Management said he would not use the notes.

“It takes some time to explain. It would take a lot more time to manage,” he said.

“It appears to me this deal was designed specifically for an institution and for a particular situation.

“But for our clients, it doesn’t make a lot of sense with all these moving parts and the longevity of this note.”

The 8% fixed rate for four years was compelling. But this period could be much shorter, he noted.

“The 8% locked in for one year is attractive. But it’s only one year. You can get called after that.

“So even though 8% for four years looks good, it really depends on when it’s called.

“After that, I wouldn’t want to sit around for 11 years with my fingers crossed.

“Between the spread on the rates and the barrier on the indices, there are too many moving parts here.

“It’s not how I invest money for my clients.

“Our objective is to get our clients into investment vehicles they can understand,” he said.

The notes are guaranteed by Citigroup Inc.

Citigroup Global Markets Inc. is the underwriter.

The note s settled on May 29.

The Cusip is 17328VMM9.

The fee is 0.5%.

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