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High yield bond

High yield bond? There's been debate on the cost of funding Citigroup raised recently from sovereign wealth fund ADIA. For a basic product, the financial knowledge of so-called gurus is shocking. Almost every "expert" on the "high yield bond" is wrong. The chart below shows the actual payoff of the Citi FORWARD sale of equity, yield enhanced with an embedded option spread. Sadly for Abu Dhabi they will likely lose big on this high risk toxic waste.

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The term sheet shows a simple structure. But media mavens don't understand it. This nicely illustrates how differences of opinion on the valuation of debt equity hybrids and people not noticing embedded optionality are opportunities for alpha. 11% was TOO CHEAP for a bank clearly facing enormous problems. I wouldn't have bought this even if it had a 22% or 33% coupon. Citi got a free option at much too low cost.

Financial engineering, model arbitrage and understanding what a security really represents allows rare investors to make money out of hordes of incompetent ones. The fact that pundits jumped on the 11% headline is a lesson in itself. That so many missed the optionality is another. Subprime CDOs also paid a "high" yield but most buyers were not informed(!) about the credit default options they were implicitly SHORT SELLING too cheaply. Why didn't the "AAA" raters see them?

Citi purchased the right to sell its stock at 31.83 and sold a 17% out-of-the money call so ADIA would participate in any upside above 37.24. Since large bank equity puts are massively bid by those seeking protection and therefore implied volatility is high, they pick up plenty of skew by writing the at-the-money put and buying a higher strike call so was obviously owed SUBSTANTIAL premium on the collar.

So the 11% coupon is explained as compensation for ADIA forgoing the 7% dividend yield available from Citi common, the high embedded option spread that Citi bought, the typical equity premium on a mandatory CB and the tax treatment. There are also other terms in the deal that offer some protective rights if or more likely WHEN the C stock goes further down. For the record I am own far out of the money LEAP puts.

The 11% coupon convertible to a 4.9% stake were the same terms offered in the convertible preferred bought by Prince al Waleed bin Talal al Saud the last time Citi got into trouble. The credit cycle repeats but lessons are NOT learnt; SIVs and CDOs now, real estate loans and broken LBO debt in early 1990s(!), and subprime countries don't go broke(!!) in 1980s. Over 30 years of financial innovation but little has changed with mismanagement and misunderstanding of credit risk.

Since billions and trillions get confusing, suppose an investor with a $90,000 portfolio decided to risk $750 on a major bank in distress and whose stock was below its high. I don't think anyone would see that as particularly risky. ADIA has about 0.8% of its portfolio in the trade. Even if Citi stock goes to zero it will not be a disaster though quite rightly they won't be happy. Having written a put at a level they would presumably be content to own the stock and get paid a dividend plus the embedded option premium until they take formal equity ownership in 3 years or so. Panic is high, vol is high, vol skew is high, the current dividend yield seems high; why not bet a small proportion of their portfolio?

What other financing choices did Citigroup have? Why not a domestic investor like Berkshire Hathaway who DOES have the cash instead of a sovereign wealth fund? My guess is Warren Buffett did not want to tempt fate from a similar situation he had ages ago with Salomon, now part of ... Citigroup. In September 1987, as a "white knight" he bought a Salomon convertible preferred with a similar "high" dividend (9% then) and "low" conversion price.

Interestingly the deal was done with the stock at 31 and convertible at 38, almost the same situation as now. A few weeks later came the October crash of that year obviously taking Salomon stock way down. The price subsequently climbed the next few years ALMOST to the strike. But then the Treasury Bond scandal erupted hurting the stock price again. Ultimately it was a fair trade for BRKA but I doubt they had appetite for a repeat.

There might have been an even "cheaper" financing source for Citi. Hedge funds might have been interested. After all Citadel just poured $2.5 billion into E-Trade ETFC. And RAB Capital and SRM Global FAILED to catch that falling knife called Northern Rock NRK.L. Trading the optionality and mispricings in large bank mandatory convertibles has been quite lucrative over the years. When time ran out for the Japanese city banks, convertibles were issued for similar reasons and turned out to be both good investments and trading vehicles for volatility monetization.

We may yet see futher equity financing emerge for Citigroup and they will be glad to have got an initial $7.5 billion done with an investor who won't short sell the common stock as a hedge, which is what I would have done. The structure also improved terms if Citi needs more than another $5 billion which it certainly will. With ordinary covertible bond issuance so much "pre-hedging", "pre-bookbuilding" and "wall-crossing" goes on that it would have forced the equity price down even more. Less negative effect on the stock price is a reason mandatory CBs are preferable for the issuer than ordinary CBs.

With some financial engineering and restructuring of cashflows the 11% coupon could probably have been as 0% or 20% by changing various preferential rights, the capital structure, optionality, convert strikes or other aspects of the deal. What would the headlines have said then? "0% - Massive vote of confidence in Citigroup as it borrows at 400bp less than the US government?" or "20% - Citigroup forced to pay far above subprime rates as bankruptcy looms?". The reality is that this was effectively a forward sale of equity with a yield enhancing option premium NOT debt finance.

Commentary ranges on the pricing from Citibank junk bond to the more accurate and remarkably cheap Libor+150bp. Academic John Bilson even thinks there weren't any hidden options at all which explains why he is a finance professor! Those who know, do; those who don't know, teach; those who haven't a clue become tenured economics academics.

While the "experts" say markets are becoming efficient and opportunities getting arbitraged out, it is reassuring to see disagreement on this, and in fact, every security. The more complex, interconnected and innovative global investment products get, the more skill is required to understand and value them. That is why it is worth paying 2 and 20 to those able to identify mispricings in the markets and capitalize upon them. And why alpha really is portable; it transports itself from the many market participants and financial geniuses that think they understand to the few that really do. Quality expertise costs.

It doesn't matter what country an investor is in or whether they are institutional, high net worth or low net worth; the requirements are basically the same. Reliable absolute returns with MINIMAL drawdowns and volatility, performance that MORE than compensates for the risk and fund managers who can tell at a glance if a security is ultimately debt or equity and have the models and experience to value it. Detecting embedded options in capital raising structures helps too.

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