To be too good to be true? Unusual Citigroup Preferred Issue yields 10%.

text size

An unusual one

Citigroup

Preferred stock issuance has an outsized current yield of about 10% at a time when most big bank preferred stocks are yielding in the 6% to 7% range.

The $2.2 billion Citigroup Capital Series XIII issue, trading on the NYSE as C Pr N, is a special type of preferred stock known as a trust preferred stock, or squads. The Citigroup Trups were issued to the federal government in the wake of the financial crisis, and the Treasury then sold them on the public markets in 2010.

The situation surrounding the Citigroup issue and why it is pending when Citi is paying so much more interest on it than other securities is both complicated and a little mysterious.

The interest rate on the issue will be fixed or reset quarterly at 6.37% percentage points above LIBOR, the London Interbank Offered Rate, a key short-term interest rate currently around 5%.

With short rates rising, the preferred rate is now around 11%, up from 6.5% in late 2021 when short rates were near zero. The current rate compares to a rate of 7.375% on a new Citigroup preferred deal that was issued earlier this year and was aimed primarily at institutional investors.

Citigroup Capital Preferred’s effective yield is a little under 10% as shares trade at nearly $28, a more than 10% premium to the face value of $25 per share. Most preferred shares are issued at $25 and are now trading around that price or at a discount. There are 89 million shares of Citigroup (Ticker C) outstanding.

Few, if any, preferred issues from top US banks yield as much — and neither do their bonds. Given the high yield, Citigroup’s preferred stock was one of the better-performing issues in the $400 billion preferred stock market.

However, the high return comes with risks. Citigroup can redeem the issue for $25, which would result in an immediate loss of about 10% for holders.

Despite having to pay such a high yield, Citigroup chose not to redeem the preferred shares because it was able to do so in 2015. That has encouraged investors to believe that the bank may keep the preferred shares outstanding until they mature in 2040. Why?

The company has stated in the past that this would be uneconomical. Due to an accounting quirk, the securities are reported on Citigroup’s balance sheet at approximately $1.5 billion, rather than at their approximately $2.2 billion face value. A repayment would cost $2.2 billion at face value of $25. This would result in a book loss of more than $700 million.

“If we redeemed that, we would take a big hit to our P&L. And that’s exactly how accounting worked on that certainty,” John Gerspach, Citigroup’s chief financial officer, said on a 2017 conference call. “The decision to redeem this security is largely an economic decision. Is it worth taking a big loss to pay back?”

In a statement to Barron’s, Citigroup said, “As we have stated in the past, the carrying value of this grandfathering on the balance sheet makes it economically more attractive to leave it outstanding than to terminate it at this point. We keep checking this on an ongoing basis.”

There’s a big difference between Citigroup’s Trust Preferred Stocks, which are considered debt, and regular preferred stock, which is a senior form of equity. Citigroup pays interest on a subordinated debt issued to a trust called Citigroup Capital XIII, which then passes the payments on to investors. Citigroup benefits from this because, unlike preferred stock dividends, the interest payments are tax deductible. Investors don’t get a tax break on Citigroup Trust’s preferred dividends, unlike most regular preferred dividends, making retirement accounts the best place to own the securities.

Banking regulations enacted in the wake of the financial crisis prohibit favoring trust as a component of Tier 1 bank capital, but have inherited Citigroup’s problem. This gives Citigroup an incentive to keep the preferred shares outstanding.

The actual cost of the preferential issuance is lower than Citi’s current rate of 11% because the distributions are a deductible interest expense, which brings costs down to under 9% (assuming a tax rate of around 20%). Quiet. The tax savings aren’t big enough to make them cheaper than standard preferred stocks, whose dividend payments aren’t deductible.

Citi will move the short-term benchmark for Trust Preferred from LIBOR, which expires, to SOFR. The new spread over the three-month SOFR will be 6.63 percentage points, up 0.26 percentage points from now.

High returns come with risks. Investors have done well holding Citigroup Capital XIII Preferred over the past few years, but there’s no guarantee Citigroup will keep it outstanding. The bank’s unwillingness to pay back the preferred shares offers investors some consolation.

“It’s one of the few preferred stocks on the market that benefits from higher interest rates because it floats with SOFR,” said David King, co-manager of the Columbia Flexible Capital Income Fund, which has owned the Citi issue for some time. “Although it is trading above its call price, which poses a potential risk, we do not expect Citi to terminate it anytime soon as regulators consider increasing capitalization requirements for all banks following recent regional bank failures,”

Maybe that’s consolation enough.

Write to Andrew Bary at andrew.bary@barrons.com