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Citigroup has a preferred with a big payout, but it comes with a risk.
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An unusual
Citigroup
preferred stock issue has an outsize current yield of about 10% at a time when most preferreds from big banks yield in the 6% to 7% range.
The $2.2 billion Citigroup Capital Series XIII issue, which is publicly traded on the NYSE as C Pr N, is a special type of preferred known as a trust preferred securities, or Trups. The Citigroup Trups were issued to the federal government in the wake of the financial crisis, and Treasury then sold them into the public markets in 2010.
The situation involving the Citigroup issue and why it remains outstanding when Citi has to pay so much more interest on it than on other securities is both complicated and a little mysterious.
The interest rate on the issue floats, or resets, quarterly at 6.37% percentage points above LIBOR, the London interbank offered rate, a key short-term interest rate now around 5%.
With short rates rising, the rate on the preferred is now about 11%, up from 6.5% in late 2021 when short rates were close to zero. The current rate compares with a rate of 7.375% on a new Citigroup preferred deal issued earlier this year that was geared mainly toward institutional investors.
The effective yield on the Citigroup Capital preferred is a little under 10% because the shares trade at nearly $28, a more than 10% premium to the face value of $25 a share. Most preferreds are issued at $25 and now trade around that price or at a discount. There are 89 million shares of Citigroup (Ticker C) preferred outstanding.
Few, if any, preferred issues from top U.S. banks yield as much—and neither do their bonds. Given the high yield, the Citigroup preferred has been one of the better-performing issues in the $400 billion preferred stock market.
The high yield, however, comes with risk. Citigroup can redeem the issue for $25, which would result in an immediate loss of about 10% to holders.
Despite having to pay such a high yield, Citigroup has opted not to redeem the preferred since it could do so in 2015. That has encouraged investors to believe that the bank will leave the preferred outstanding, perhaps until its maturity in 2040. Why?
The company has said in the past that it would be uneconomic. Due to a quirk in accounting rules, the securities are carried on Citigroup’s balance sheet for about $1.5 billion, not their face value of about $2.2 billion. A redemption would cost $2.2 billion at the face value of $25. This would result in an accounting loss of more than $700 million.
“If we were to redeem this, we would take a large hit to our P&L. And that’s just the way that the bookkeeping has worked on that security,” said Citigroup chief financial officer John Gerspach in 2017 on a conference call. “The decision to redeem that security is largely an economic one. Is it worth taking a large loss to redeem?”
In a statement to Barron’s, Citigroup said: “As we’ve stated in the past, due to this grandfathered security’s carrying value on the balance sheet, it’s more attractive economically to leave it outstanding rather than to call it at this time. We continue to assess this on an ongoing basis.”
There’s a big difference between Citigroup’s trust preferred, which counts as debt, and regular preferred stock, which is a senior form of equity. Citigroup pays interest on a subordinated debt issued to the trust, called Citigroup Capital XIII, which then passes on the payments to investors. This benefits Citigroup since the interest payments are tax deductible, unlike preferred stock dividends. The investors get no tax break on the Citigroup trust preferred dividends unlike those on most regular preferreds, which makes retirement accounts the best place to own the securities.
Bank regulations passed in the wake of the financial crisis disallowed trust preferred as a component of Tier 1 bank capital but grandfathered the Citigroup issue. This gives Citigroup an incentive to keep the preferred outstanding.
The effective cost of the preferred issue is lower than the current 11% rate for Citi since the distributions are a deductible interest expense, which reduces the cost to under 9% (assuming a tax rate of about 20%). Still. the tax savings aren’t large enough to make them less expensive than standard preferreds, whose dividend payments aren’t deductible.
Citi will be shifting the short-term benchmark for the trust preferred from LIBOR, which is being phased out, to SOFR. The new spread above three-month SOFR will be 6.63 percentage points, 0.26 percentage points more than it is now.
High yields come with risk. Investors have done well holding the Citigroup Capital XIII preferred in recent years but there’s no guarantee Citigroup will keep it outstanding. The bank’s unwillingness to redeem the preferred does offer some comfort to investors.
“It is one of the few preferred stocks in the market benefiting from higher interest rates, because it floats with SOFR,” says David King, co-manager of the Columbia Flexible Capital Income Fund, which has owned the Citi issue for some time. “Although it trades above its call price, which is a potential risk, we don’t expect Citi will call it soon, due to regulatory consideration of increasing capitalization requirements for all banks after recent regional bank failures,”
Maybe that’s comfort enough.
Write to Andrew Bary at andrew.bary@barrons.com
