Registered: May 2007
11-28-07 11:48 AM
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."
"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."
The Alphaville post ends up by noting:
"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, otherwise known as reverse convertibles)
* 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 option as well. It doesn't participate (much) in the rise from the low strike to the high strike. Perhaps, just perhaps, the value of this call option 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):
* ADIA pays $7.5bn for 235m shares of citi stock at 31.83, at, say, 7% yield
* ADIA sells 235m (ish) calls 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 dividend enhancement is probably worth 12% of the deal amount of $7.5bn. With sensible assumptions, the value of the call options sold back to Citi is around 8%, so the 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.
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".