Thursday, August 14, 2008

Citigroup: Do you think I had a choice?

(Accrued Interest) Citigroup issued $3 billion of a new 5-year senior bond issue on Tuesday. This was Citi's first offering since May, and the first billion dollar sized new issue from a major financial since Berkshire Hathaway came with a 5-year deal on July 30.

Access to the bond market is critical for all large financial institutions. Citigroup's issue proved that access is very expensive. The new issue was sold at a yield spread of 337.5bps over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup's 5.5% bond due in April 2013 was bid at +275. Since the 5.5% bonds have approximately the same maturity and seniority of the new debt, its yield spread is directly comparable to the new issue. Hence the difference in spread levels means that Citigroup had to pay more than 60bps in extra yield in order to find enough investors to buy their debt. Not good.

This highlights some very telling facts about today's market. First, this is an extreme concession for a plain vanilla debt sale of a Aa3 rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and 5-year swap spreads closed at +98.5. You own the bond at +337.5bps, swap out the interest rate risk for 98.5bps, and the credit risk for 160bps. You are left with 79bps for free. This arbitrage won't last long, at least not at that level, so expect Citi cash bonds to tighten and CDS to widen in the near term.

Finally, this highlights an important risk of owning bank and brokerage bonds, and the opportunity that new issues offer. Under normal conditions, banks and brokers are routine issuers of new debt. The fact that accessing the bond market is currently so expensive is keeping issuers on the sidelines, but in fact, that's pent up demand for debt financing. As soon as conditions improve, expect a flood of new bond issues, all of which will come at a substantial concession to secondary trading levels.

But its common for the initial trading of the new debt issue to be tighter than the initial offer spread. The idea is that while Citigroup needed to pay a significant yield premium to clear $3 billion in bonds, once that initial supply has cleared, trading in the issue should resume at close to pre-supply levels. Indeed, the new Citi bond is traded initially about 10bps tighter than its original spread, although it now only slightly tighter.

So even if you believe we're already past the bottom for financials, tread carefully into financial bonds, and wait for new issues to make your allocation.

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