Its not always that both the venerable FT and the Wall Street Journal dive into a story and miss the point so absolutely that you have to question their sanity. The Alphaville chaps have summarised the two articles relating to the Citi financing deal with the AbuDhabi Investment authority under "Junk Citi" as the headline.
Selected quotes include:
"The securities will also pay a fixed coupon of 11 percent per year, payable quarterly. That may seem steep, but after accounting for the fact that 60 percent of that coupon is tax-deductible, the coupon rate is similar to the dividend rate on Citi’s shares, a person familiar with the matter said."The Alphaville post ends up by noting:
"Citi is paying a higher interest rate than companies that borrow on the high-yield, or junk-bond, market; currently they pay roughly 9% for straight bonds. Typically, convertible bonds pay lower interest rates than straight bonds, although a particular bond’s structure could affect the interest rate paid."
"And why this highlighting of the fact that interest payments on the notes will be tax deductible (like most forms of debt)? And does 11 per cent represent a “slight premium” to a seven per cent yield on Citi stock? That’s actually a premium of 57 per cent. Even after the spurious tax argument, it is difficult to see how this funding can be costing much less than 9 per cent."Oh dear. Oh dearie dearie me. Gentlemen, there was a clue in first quote. ....."although a particular bond's structure could affect the interest rate paid". You bet it can. Lets take a look at the key features of the deal termsheet.
- Size: $7.5bn
- Type: Mandatory convertible (DECS is the Citi brand for these ubiquitous instruments)
- Payment rate: 11%, quarterly
- Term: Approx 4 years
- Settlement amount: (a) 235m citi shares if stock below 31.83
(b) 201.39m shares if stock above 37.24
(c) straight line interpolation between these numbers.
The 235m shares @ 31.83 is, indeed, equivalent to a $7.5bn equity financing. But ADIA has effectively sold a call spread to Citi as well. It doesn't participate at all in the first 17% rise from the low strike to the high strike. Perhaps, just perhaps, the value of this call spread is equal to the 4 year additional yield premium on the DECS. Lets break down the deal into alternative components which have an identical cashflow profile (assuming pricing the day the deal was struck at 31.83):
The dividend enhancement is probably worth 12% of the deal amount of $7.5bn. With sensible assumptions, the net value call spread is around 8% in Citi's favour, so the remaining cost to Citi is around 4% or about 1.5% pa over the weighted average life of the deal. Put another way, Citi has raised tax deductible, upper tier capital funds for 4 years at a cost equivalent to another financing source of Libor+150. Smart business. It may even be that Citi's stock has suffered since the deal was struck in part due to Citi itself hedging out its long callspread position.
- ADIA pays $7.5bn for 235m shares of citi stock at 31.83, at, say, 7% yield
- ADIA sells 235m calls on Citi stock strike 31.83 expiry 2010-11 (staged)
- ADIA receives 201m calls on Citi stock strike 37.24 expiry 2010-11 (staged)
- ADIA receives 4% pa dividend enhancement for 2.5-3.75 years (staged)
The FT and the Wall Street Journal are guilty of sensationalist journalism and have totally missed the point in their quest to find the worst possible slant on any investment bank's activities. I suppose this is in vogue at the moment. Perhaps if they had wanted to batter ADIA instead of Citi, the headline might have been "Unsophisticated Arab financiers write massive put option on US investment bank".
Disclosure: No position in Citi
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8 Comments:
Jesus, Andrew, thanks for the lucid post! All the other crap being written is beyond comprehension (because the deal is beyond the writers' comprehension). You know the business and are obviously spot-on. Congratulations and thanks.
Ok do you think this is what they have done? As far as we understand this is a mandatory convertible prefered which
means that it will automatically convert into stk in 2010 and 2011. the
lower strike on the structure is 31.83 which means the buyer is short a
put struck there and long a call at 37.24. the short put position has
much greater value than your long call so the coupon must be higher to
offset the effective sale of the put. Also since the structure does not
convert until 2010-2011, the holder will NOT be receiving the common
div. with a yield of 7.4% that is quite a large loss So the 11% is
effectively made up of the loss of the 7.4% div yield and the difference
in value between the put you are short and the call you are long. Its
basically a forward stk sale, not a 11% debt instrument.
What's driving me nuts is that I think I've almost got it. The implicit call options embedded in the deal net out in C's favor to the tune of 8% of the face amount. The present value of the dividend premium over common nets out in ADIA's favor to the tune of 12% of the face amount. Ergo, the true cost to C is 4% or 150bps annualized.
OK. But how does this suddenly equal Libor plus that same 150 bps? Shouldn't it be the 7% common dividend plus the 150 bps?
I'm guessing (wildly) that this has something to do with the implicit collateral yield on the options position. But I don't understand how.
Please, Mr. Clavell, could you explain? I'd be ever so grateful. This has been bugging me all day.
I think ADIA got a very good deal. The div yield of 7% when the stock is down more than 50% on the year? Also, how certain was the dividend. As for the put they are writing, lets look again. They are putting 7.5bn into something which is too big to fail and that put is being written at a point when stock is down mre than 50% while they aer long the call. That is a good trade!
Roger Ehrenberg helpfully clarified my post with the following: "after reading the comments it might be easier to describe the structure from Citi's perspective as a stock sale to ADIA at 31.83 and the purchase of a 31.83/37.24 call spread settled in Citi shares. Below 31.83, Citi has sold shares at a fixed price. Between 31.83 and 37.24, Citi has sold shares at the price at which the 31.83 call is exercised. Above 37.24, Citi has sold shares at 37.24. The value of the purchased call spread is what accounts for the difference between the dividend rate and the coupon rate. As it relates to call spread valuation there are issues certainly of volatility levels and skew between the strikes, expected dividend rates (as one of your commenters properly raised), etc., but this is the punch line. Hope this helps."
He is right, of course. I used "short a call" liberally instead of being more precise (callspread), though the vol/div/skew assumptions are less relevant to a point. The key is of course being citi's net option position (long the 235m calls at 31.8 and short 201m at 37.5) has enough value for them pay the additional yield on ADICs mandatory convertible.
If citi now cut the dividend, the (presumably delta hedged) option position the converts desk has on board is considerably more valuable. Perhaps the deal in itself is signalling a dividend cut.
I think I got you, when I calculate it out, because the number of options being bought sold is different too, enhancing the difference for Citi (at about 8%). However, the Dubai guys are selling options back to Citi at 50% volatility. Doesn't seem like such a bad deal to me.
A comment and manual trackback: thanks much for posting hard numbers. I did a roundup post contrasting your info with coverage from Bloomberg, Marketwatch and Reuters.
Could you comment on how the "purchase contract reset adjustment clause in the term sheet" changes the deal now that Citi has (I think) issued the additional $5 billion in equity at less than $31.83/share.
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