If you are one of the many investors who, in the post-financial-crisis world, has shifted your focus from a return on capital to a return of capital, you have likely spent some time perusing various parts of company capital structures in search of steady income. This includes not just common stock but also preferred stock, subordinated debt, and unsubordinated debt. Income-seeking investors, who want to avoid some of the volatility typically associated with the common stock of a company, may be tempted to focus on preferred stocks. After all, preferred stocks usually have higher yields than common stocks and also usually have higher yields than the upper parts of a company's capital structure. What exactly do I mean by a company's capital structure? In its simplest form, a capital structure looks something like this:
Additionally, it should be noted that within the upper two tiers that comprise a company's debt, there can be multiple levels of seniority. One such example would be the difference between senior (unsubordinated) secured debt and senior (unsubordinated) unsecured debt. Another example is the difference between subordinated debt and junior subordinated debt. As should be expected, in the event a company goes out of business, those at the top of the capital structure are the first to be made whole (in whole or in part), and those at the bottom of the capital structure are usually left with nothing.
As previously mentioned, preferred stocks typically yield more than other parts of the capital structure. This makes sense as preferred stocks are a hybrid of debt and equity that needs the higher yields to attract both debt and equity investors. Equity investors will demand higher yields to give up the possibility of price appreciation from the common stock. Debt investors will demand higher yields in order to entice them to move down the capital structure. With this in mind, if you had the opportunity to lock in a higher yield on the subordinated debt of a company than on the preferred stock, would you? I suspect there are plenty of investors that would. And those investors will likely be intrigued by the yield anomaly that currently exists in Citigroup's (C) capital structure.
Before revealing the anomaly, let's take a look at Citigroup Inc.'s capital structure from the preferred stock up to senior debt.
Junior Subordinated Debt
Regarding the "See below" in the Junior Subordinated Debt box in S&P's column, Citigroup's website shows no S&P rating for the Junior Subordinated Debt. QuantumOnline.com, a popular site for gathering information on preferred stocks, shows Citigroup's Junior Subordinated Debt as having a BB rating from S&P.
According to the "Fixed Income Investor Relations" section of Citigroup's website, there are currently six series of preferred stock outstanding. Of the six series outstanding, just two are exchange-listed securities, the Series C and Series AA preferreds. The Series AA preferred is trading so far over its liquidation preference (recently asking $30.25 versus a $25 liquidation preference) and is so illiquid that I do not think it is even worth considering. That leaves just one exchange-traded preferred, the Series C, that will garner the majority of attention from investors.
The Series C, Citigroup Inc., 5.80% non-cumulative preferred stock pays cash dividends in the amount of $1.45 per depositary share per year, quarterly, on January 22, April 22, July 22, and October 22 of each year. The dividends are not cumulative, which means that if a dividend is not declared on the preferred stock for any particular dividend period, the dividend will not accrue, and Citigroup will be under no obligation to pay the missed dividend in the future. Moreover, the Series C preferred has no maturity date. It is, however, callable, in whole or in part, at $25 per share, on any dividend payment date on or after April 22, 2018, or in whole or in part, at $25 per share, at any time within 90 days following a "Regulatory Capital Event" (defined on page S-10 of the Prospectus Supplement dated March 19, 2013). Additionally, according to the Prospectus Supplement, dividends paid on the Series C preferred stock "generally will be taxable at the preferential rates applicable to long-term capital gains." Furthermore, holders of the Series C preferred stock will not be able to convert the preferred stock into shares of the common stock. Last, the Series C preferred stock will rank senior to Citigroup's common stock and junior to all existing and future indebtedness of Citigroup. This information and more can be found in the Series C preferred's Prospectus Supplement, found here.
Three examples of existing indebtedness to which the Series C preferred ranks junior are CUSIPs 172967DR9, 172967CC3, 172967BU4, each of which is Citigroup Baa3/BBB+/BBB+ rated subordinated debt.
CUSIP 172967DR9 refers to the 6.125% coupon, August 25, 2036 maturing notes, recently offered for 95.74 cents-on-the-dollar, a 6.482% yield-to-worst.
CUSIP 172967CC3 refers to the 6.000% coupon, October 31, 2033 maturing notes, recently offered for 95.693 cents-on-the-dollar, a 6.38% yield-to-worst.
CUSIP 172967BU4 refers to the 5.875% coupon, February 22, 2033 maturing notes, recently offered for 94.506 cents-on-the-dollar, a 6.368% yield-to-worst.
Each of the three Citigroup subordinated debt securities has a conditional call at par described in the Prospectus Supplements as a "Redemption for Tax Purposes." The Prospectus Supplements can be found here, here, and here.
Notice the yields of 6.482%, 6.38%, and 6.368% on the Citigroup subordinated notes. Based on its recent close of $23.15, Citigroup's Series C preferred stock, which is two steps lower in the capital structure than the subordinated notes mentioned above, is yielding 6.26%. The Series C perpetual preferred (no maturity date) is actually yielding less than the subordinated debt. As long as this remains the case, income-focused investors wanting to add Citigroup exposure to a diversified portfolio should, in my opinion, forget about the preferred stock and instead buy the subordinated debt.
Even if the subordinated debt were yielding slightly less than the preferred stock, I would still favor it for a few other reasons. With the higher yields, however, it makes the decision much easier. In addition to the higher yields, I like the fact that the Citigroup notes have stated maturity dates at which the face value of the notes will be repaid (absent a default). The preferred stock has no maturity date, and it is technically possible for some shareholders to be underwater on their shares forever. I also like the fact that the Citigroup notes only have a conditional call for tax purposes, a not-so-uncommon redemption feature that is rarely invoked. The preferred stock, on the other hand, is callable in fewer than five years. For long-term-oriented income investors, the preferred stock's call features create a level of uncertainty that Citigroup's subordinated debt does not.
Another level of uncertainty preferred shareholders have that bondholders do not have is the fact that dividends are not cumulative and could not be declared for a period of time. The aforementioned subordinated notes have fixed-rate coupons that do not rely on frequent declarations from the company in order to pay bondholders.
While yields, maturity dates, call features, and the payment structure favor the subordinated debt over the preferred stock, I would like to address three concerns I envision some investors may have about purchasing Citigroup's notes.
1. Liquidity - Individual corporate bonds have a reputation for wide bid-ask spreads and very little trading volume. But that's not the case with the Citigroup CUSIPs mentioned above. At the time this article was written, the 5.875% coupon 2033 maturing Citigroup notes had a bid-ask spread of just 0.61%, and the 6.000% coupon 2033 maturing notes had a bid-ask spread of just 0.44%. The Series C preferreds regularly trade with bid-ask spreads of roughly $0.10. Based on its recent closing price of $23.15, a $0.10 spread is roughly 0.43%, in line with the bid-ask spreads of Citigroup's 2033 maturing notes. The 2036 notes do admittedly have a wider bid-ask spread of approximately 1.8%. In the broader individual corporate bond space, however, a 1.8% bid-ask would certainly not be considered among the worst.
In terms of volume, all three subordinated Citigroup notes are regularly traded, and the depth of the market on each of the notes is superior to the depth of the market in the preferred shares (depth measured in dollar volume of shares/notes represented in the market). If you are an institutional trader, the dollar volume liquidity should certainly be of importance to you.
2. If benchmark Treasury rates keep rising, bond prices will fall - Yes, rising benchmark Treasury rates will put upward pressure on corporate bond rates. But the spread-to-Treasuries is also an important component in determining an individual corporate bond's price direction. Should Citigroup's spread-to-Treasuries contract, it could offset further rises in benchmark rates. Moreover, if you are a long-term investor with the wherewithal to hold a bond to maturity (just as you would hold the preferred stock for many years), the mark-to-market movements in the bonds become largely irrelevant. As long as you've selected a credit risk and yield with which you are satisfied, you can hold the security, collect the coupon, and ignore the unrealized gains and losses that will occur over time. Finally, the perpetual preferred stock's price will also not be completely immune from rising rates.
3. Taxes - It is true that the dividends from Citigroup's Series C preferred stock will be taxed at preferential dividend tax rates, whereas the interest income from the notes will be taxed as ordinary income. From my perspective, this is not enough to shift the balance in favor of the preferred stock over the subordinated notes given the current yield anomaly and other features of the securities. But each investor will have to determine for him- or herself the importance of the tax differential.
The anomaly in Citigroup's capital structure in which investors can now purchase subordinated debt at a higher yield than the preferred stock is something investors looking to gain exposure to Citigroup should consider before purchasing the preferreds. When combining the higher yields with the other features discussed in this article, I would definitely choose Citigroup's subordinated debt over Citigroup's Series C perpetual preferred non-cumulative stock.
Note: The symbol for Citigroup's Series C preferred stock will vary depending on the broker or financial website you use. Some examples of the symbol include C-PC, C prC, and C/PC.
Additional disclosure: I am long CUSIP 172967CC3 as well as other Citigroup unsubordinated and subordinated debt.