New C-J Preferred: Citi Seriously Underplayed 'Too Big To Fail' Status

Would you guess that investment grade preferred stocks would trade for a higher or lower price than speculative grade preferred stocks, other things being equal?

What about market demand in general for the two, as measured by average daily trading volume; would you think that the market would beat a faster path to the door of an investment grade preferred or a speculative grade preferred (again, other things being equal)?

Obviously, and since preferred stocks started being issued and rated decades ago, the market tends to favor investment grade preferreds over their speculative grade twins since at least someone seems to think that the investment risk is lower (and, historically, they'd be right).

Citigroup has introduced five nearly identical trust preferred stocks over the last 3.5 years. All five issues have fixed quarterly dividend payments; all have the 'cumulative' dividend requirement (meaning that if Citi misses a payment they still owe you the money); all are callable five years after their respective IPO dates; and all have the same $25 par value.

But beyond their individual dividend rates, the economic conditions that existed when each was introduced were also quite different. Citi issued two of these five issues before the crisis, two during the crisis with the fifth (symbol: C-J) just eight trading days ago.

What makes this interesting is that in February, just before Citi introduced C-J, Moody's downgraded Citi trust preferreds to speculative grade (to Ba1). That means that when C-J hit the market on March 19, 2010 it was the first of these five trust preferred stocks to be born as a speculative grade issue.

This timing allows us, by comparing C-J to the previous four Citi trust preferred stocks, to see just how much investors penalize Citi for its trust preferred stocks being downgraded.

Another thing that makes C-J interesting and unique is that it is the first (and only) trust preferred stock to be issued by Citi since Citi was anointed 'Too Big To Fail.' Citi did not adorn the Too Big To Fail crown until the Big Bank Stress Tests in April 2009 well after the previous four Citi trust preferred stocks had been issued.

So here we have C-J, a new Citi trust preferred stock downgraded just prior to its March 19, 2010 birth and issued by a company that is the poster child for 'Too Big To Fail.'

Would investors penalize Citi for the downgrade and shun the new C-J (compared to Citi's earlier issues which were investment grade at the time of their introductions) or would investors ignore the downgrade and attach a premium to Citi's Too Big To Fail status by falling all over themselves to buy the new C-J (again, when compared to how investors behaved toward the prior issues)?

Because of the rare and coincidental timing of the downgrade and Citi's recently achieved Too Big To Fail status, we have an unusual opportunity to see just how much investors really believe that Citi is, in fact, Too Big To Fail.

If we look at how the market received Citi's earlier four trust preferred stocks (C-O, C-U, C-F and C-G), issued prior to the downgrade and also prior to the Too Big To Fail realization, and compare that reception to what investors did with C-J upon its introduction on March 19, 2010, we can get a pretty good idea of just how much investors believe that Citi is, in fact, Too Big To Fail despite the February 24, 2010 speculative grade downgrade from Moody's.

If investors doubt the Too Big To Fail anointment of Citi, and put more faith in the new speculative grade rating from Moody's, we would expect to see a floundering market price in the days following the introduction of the new C-J, much more so than the previous four Citi trust preferred stocks had experienced, and weaker market demand in terms of average daily share volume than we saw with the others back when they were issued.

This chart looks at these two key metrics of how the market received these five Citi trust preferred stocks at IPO. For each of these five Citi trust preferreds you can see (1) the market price behavior during the first eight days after introduction (this is the number of days since C-J was introduced) and (2) the initial market demand in terms of the average number of shares that buyers demanded during these first days of trading (these are primarily large institutional buyers in the early days of trading).

The market price of C-J, despite having been downgraded just prior to its March 19, 2010 introduction, jumped straight up and above $25.70, well above its $25 par value, from the outset. And the price has stayed there, day after day with almost no variation (standard deviation = $0.04).

With the prior four trust preferred stocks, which all had investment grade ratings at the time of their IPO, the market price struggled much more to climb and none came anywhere close to the $25.70 price within their first eight days as we saw with C-J. C-J achieved a higher market price, and did so more quickly, than any of the prior issues despite its speculative grade rating.

And the demand for shares of C-J dwarfed all prior issues with the average daily share volume of C-J exceeding 1.2 million.

While there were certainly a number of additional issues affecting investor behavior, it is fair to say that if the Moody's downgrade scared off investors, you sure cannot tell it by looking at how investors received C-J upon its introduction a few days ago.

Investors certainly acted as if Citi does, in fact, enjoy a certain amount of protection from the U.S. government.

But Citi appears to have underplayed its enviable Too Big To Fail position. The other four Citi trust preferred stocks were yielding about 8.1% when C-J was introduced a few days ago. But Citi introduced C-J at 8.50%, a full 0.4% higher than the market was saying they were willing to pay $25 for.

This extra 0.4% premium that Citi tacked onto C-J, presumably to compensate investors for the new speculative grade rating, was probably not necessary. This extra 0.4% premium costs Citi an extra $8 million in dividend expense per year to C-J shareholders. And the irony is that Citi did lower the dividend rate on C-J just before they introduced it, but apparently they could have lowered it another 0.4%.

Since Citi is stuck with paying these dividends until at least C-J's call date five years from now, not appreciating how much investors believe that Citi is Too Big To Fail, even in the face of being downgraded to speculative grade, may have just cost Citi a minimum of $40 million.

I guess it is only good to be king if you are aware of it.

Many Happy Returns.