Citi's Bond Issuance Highlights Risk in Financials

Citigroup (C - commentary - Cramer's Take) issued $3 billion of a new five-year senior-bond issue on Tuesday. This was Citi's first offering since May, and the first billion-dollar-sized new issue from a major financial since Berkshire Hathaway (BRK - commentary - Cramer's Take) came with a five-year deal on July 30.

Access to the bond market is critical for all large financial institutions. Citigroup's issue proved that access is very expensive. The new issue was sold at a yield spread of 337.5 basis points (bps) over the 5-year Treasury. Prior to the announcement of the new issue, Citigroup's 5.5% bond due in April 2013 was bid at +275. Since the 5.5% bonds have approximately the same maturity and seniority of the new debt, its yield spread is directly comparable to the new issue. Hence, the difference in spread levels means that Citigroup had to pay more than 60bps in extra yield in order to find enough investors to buy their debt. Not good.

This highlights some very telling facts about today's market. First, this is an extreme concession for a plain vanilla debt sale of an Aa3-rated bank. In 2006, the concession might have been 5 or 10bps at the most for a new issue. Alternatively, Baa-rated Deutsche Telecom (DT - commentary - Cramer's Take) recently brought a new 10-year issue, and the concession was around 15bps. This tells you that while there are buyers of Citigroup debt, they pretty much have to give it away.

Second, at a spread to Treasuries of +337.5, the deal has a very large negative basis to credit default swaps. This means that buyers of Citi bonds could also buy CDS and realize an arbitrage. Citi CDS closed Tuesday at 160bps and five-year swap spreads closed at +98.5. You own the bond at +337.5bps, swap out the interest-rate risk for 98.5bps, and the credit risk for 160bps. You are left with 79bps for free. This arbitrage won't last long, at least not at that level, so expect Citi cash bonds to tighten and CDS to widen in the near term.

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At the time of publication, Graff had no positions in the stocks mentioned, although positions may change at any time.

Tom Graff is a Managing Director of Cavanaugh Capital Management, a registered investment advisor in Baltimore Maryland. The opinions expressed here are Graff's own and in no way are the statements of Cavanaugh Capital Management, and may or may not reflect the strategies being pursued for clients of Cavanaugh Capital Management. Under no circumstances does the information in this column represent a recommendation to buy or sell stocks. Graff appreciates your feedback; click here to send him an email.