During the past several days I have been inundated with calls and e-mails asking why CprP and CprM have not rallied in response to the price increase of C common. The most popular secondary question is: "Have the exchange terms changed?" Although the terms are preliminary (nothing is set in stone until the SEC completes its review. The review is expected to be complete sometime between the end of April and the end of June), nothing has changed. The problem lies not in a change of exchange terms, but in the price of Citi common.
In the equity-centric world of retail investing, the knee-jerk reaction is to believe the equity price is fundamentally correct and that the preferred price is incorrect. It had not dawned on a single person who contacted me that the problem lies not with the preferreds, but with the common.
The only reason CprP and CprM are trading above $2 is that there is an arbitrage to be had. Once the arbitrage is over, there will be no bid support. One may say that CprP and CprM are trading in the teens for technical reasons. After all, without the arbitrage they are non-cumulative, non-paying preferreds. The arbitrage is that if one purchases CprM and CprP in the $13.00 area and C common is better than approximately $1.80 at the time of the exchange, the arbitrage will be successful. Because of uncertainty and the cost of hedging (shorting and borrowing C common or creating synthetic shorts using options), C preferreds had been trading at roughly a 10% discount to the conversion calculation. During the past week, the disconnect has widened to over 30%.
This is for two reasons. First: The market does not believe in the $3+ C common price. Secondly: Citi shares which can be borrowed have fried up. This is creating a short squeeze. In a typical short squeeze, the share price of the stock in question will spike as shorts are covered. Once that has been accomplished, the bid support for the stock disappears. One need only look to Volkswagen's wild ride last October. The arbitrageurs, not being able to short the common and not believing in the $3+ C share price, do not bid up CprP and CprM.
I mentioned last week that the corporate bond market had not shared in the stock market's optimism because nothing had fundamentally changed. I later acknowledged that bank bond prices performed a bit better after Treasury Secretary Geithner announced his desire to rid bank balance sheets of toxic assets. With the TALF experiencing a tepid response and few positive signs in the economic data, bank bond prices have fallen once again. In fact, prices of C bonds have fallen as its share prices have rallied. Professional fixed income investors are no all that optimistic. Similarly, CprP and CprM have become provinces of institutional investors, such as hedge funds, who are the largest participants in the arbitrage. To me it appears as the problem lies on the common side. Equity prices are among the least reliable indicators in the investment world due to their potential attractiveness as speculation vehicles.
The Fed surprised the markets today and announced that it would purchase up to $300B of U.S. treasury in an attempt to lower mortgage rates. This is an example of quantitative easing. This flies in the face of yesterdays TIC flows which indicated fewer foreign purchases of U.S. securities. Although $300B is not a large number in relative terms, it demonstrates the Fed's desire to hold borrowing costs low in an attempt to jumpstart the economy. Although inflation is likely to arise down the road (probably sometime in 2010), long-term treasury yields are unlikely to respond, yet. There is no rush now to buy ETF TBT.
2 comments:
There's no rush today to buy TBT, but don't be surprised when its the most actively traded stock. Why did C rally on the open? Who really thinks a reverse split is a good thing. Proably the same people that think there are free elections in North Korea.
I still think TBT is a good long-term buy. C rallied due to short covering. It had nothing to do with perceived quality (ha, ha, ha!).
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