A Reasonable Yield With Minimal Interest Rate Risk: Citi Preferred Series K

| About: Citigroup Inc. (C)

Summary

Review Selection Method.

Key Statistics of C-K.

Call, Credit, and Duration Risks.

Compare Alternative Investments.

A Buy/Sell Recommendation on C-K.

Review of Selection Method

I begin my investment research process by selecting funds within asset classes or sectors that would be appropriate to add to my portfolio. Interest rate sensitive investments have risen to uncomfortable heights. The Lower for Longer sentiment leaves my portfolio vulnerable to any unexpected interest rate increases. A variable preferred stock would make an excellent addition to my portfolio as they have less interest rate risk and yield more than comparable bonds.

After reviewing the top holdings of several funds featured in Norman Roberts series of articles, Citi Preferred Series K (C-K) stood out asCiti Logo the best investment. C-K is a top holding in the PowerShares Variable Rate Preferred Portfolio ETF (NYSEARCA:VRP) and the First Trust Preferred Securities and Income ETF (NYSEARCA:FPE). I find it better to save the expense ratio of .50% and .89%, respectively. Using funds' top holdings as a menu of investment options gives you more control over your own investments. You can pick and choose which investments fit into your portfolio. You have the advantage of a long term perspective. You can hold onto unpopular investments without risking your career.

Key Statistics

C-K's closing price on 7/8/16 was $28.89 with a par value $25. Its coupon is 6.875% giving it a current yield of 5.95%. If you strip out the accumulated dividend, the current yield is 6.0%. All too often I see analysis stop at the current yield. However, the issue is callable on 11/14/23 resulting in roughly a 4.5% yield to call. This may sound low because the iShares U.S. Preferred Stock ETF (NYSEARCA:PFF) yields 5.68%, VRP yields 5.0%, and FPE yields 6.25%. Those are the current yields. C-K has a high current yield of 6.0%. Remember, the funds hold securities similar to C-K, but the expense ratio gets paid before you receive your dividends.

The big advantage of C-K is that on 2/15/2024 the coupon adjusts to 3 Month Libor plus 4.13%. This is much better that the popular 3% and 4% floor issues offered by Bank of America (NYSE:BAC) and Goldman Sachs (NYSE:GS) that will only adjust after Libor has increased several hundred basis points. An increase in Libor will immediately increase the yield of C-K. Libor currently sits at .65% which in the event interest rates do not increase in the next eight years, C-K will yield 4.78%, a fair yield in a low rate environment.

Below is a historical chart of the 3 month Libor, to provide perspective of what C-K's adjusted yield could be.

3 Month Libor Click to enlarge

Risks

The three big risks are call, credit, and duration. We've covered the call risk. Seven and a half years from now, C-K could be called at par resulting in a lower return than the current yield.

The credit risk is that in an economic crisis, Citigroup (NYSE:C) could suspend common stock dividends, which would allow Citigroup to suspend the preferred stock dividends. All preferred dividends must be paid before the common shares can receive any dividend; however, suspended C-K dividends are not cumulative. Payments of dividends in arrears are not required. Citi preferred shareholders lost money in the last financial crisis, but not nearly to the extent of the common shareholders. Last month Citi passed the stress test, tripled its dividend, and announced a major buyback plan. The company is in much better position to handle a financial crisis than 2007.

C-K is potentially a perpetual issue. The call date is optional at Citi's discretion. This typically leads to duration risk, the sensitivity to interest rate changes. The variable feature of C-K leads to much less duration risk than the usual fixed income investment. Call, credit, and duration are risks that all fixed income investments face. As long as you acknowledge these risks, I find them acceptable.

Comparable Investments

Once C-K is selected as a potential investment, other comparable investments should be evaluated. C-K is a fixed income investment and therefore should be compared to other Citi bonds and a long term corporate bond fund.

The 2024 Citi bond has a yield to maturity of 3.3%, lower than C-K's 4.5% yield to call in late 2023. You are receiving an additional 120 basis points for taking the additional credit risk of a suspended dividend or lower seniority in the event of bankruptcy, neither of which I view as likely. That's 36% more income. Additionally, C-K's qualified dividend receives preferential tax status. Advantage C-K.

The 2098 Citi bond has a yield to maturity of 4.6%, which is lower than if C-K does not get called and has a floating rate perpetually. Again, C-K has a beneficial tax advantage. Advantage C-K.

The Vanguard Long-Term Corporate Bond Index ETF (NASDAQ:VCLT) is extremely diversified holding 1690 different bonds with a yield of 4.09%. Top holdings include Anheuser-Busch (NYSE:BUD), GE Capital, and Verizon (NYSE:VZ). There is significant interest rate risk with an average duration is 13.9 years. It would not help me accomplish my goal of reducing my portfolio's interest rate risk. Advantage C-K.

Sources: Graph created in excel using data from Vanguard, Charles Schwab, and Preferred Stock Channel.

Recommendation

I recommend buying C-K. It has a higher yield than the common stock with lower volatility. It yields higher than comparable bonds with less interest rate sensitivity and a qualified dividend.

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Disclosure: I am/we are long C-K.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.