Last week, Citi (NYSE:C) surprised investors by not calling its Series J fixed to floating preferred share (C.PR.J) and allowing the dividend yield to float at a rate of three-month SOFR plus 430 basis points. This move offers an attractive dividend yield of 9.5%, which is unusual for a “too big to fail” bank.
While there is a slight call risk currently associated with these shares and many investors believe they will be called in December, there are circumstances that might cause them to remain issued into 2024.
It’s important to note that Citi’s decision to not call its Series J shares has nothing to do with its ability to pay preferred dividends. Rising interest rates have actually increased both interest income and interest expenses for the bank. In fact, net interest income (interest income less interest expense) is $2 billion higher on a quarterly basis compared to the pandemic period.
Another positive trend for Citi is the net interest margin, which is gradually improving after reaching its lows during the pandemic. Despite a decrease in the interest rate spread, the bank has been able to maintain a healthy net interest margin by deploying more assets into lending. This has led to a 3% year-over-year growth in lending, the highest level since the start of the pandemic.
However, Citi is facing challenges in terms of deposits, as it has seen a decline in deposits in six of the last eight quarters. This goes against the common belief that “too big to fail” banks experience consistent deposit growth. Leverage is also a concern for investors, as the bank’s leverage ratio remains above the industry benchmark, despite deleveraging efforts in recent quarters. Nevertheless, Citi holds a significant amount of cash, enough to cover nearly a quarter of its deposits and almost half of its loans. Overall, the bank’s capital structure remains conservative.
The Series J shares do have a slight call risk, but a quarterly dividend of over 60 cents (2.5% of the call price) has already been declared for payment in December. If investors purchase the shares before the ex-dividend date, a December call would result in a net gain above the current price.
Citi needs to be cautious with its decisions regarding preferred shares, as calling in more shares or engaging in common share buybacks can create issues with capital ratios, as mentioned during the earnings call. Preferred shares benefit banks by supporting capital ratios.
Investors who are interested in purchasing Series J preferred shares should consider issuing limit orders to buy. These shares, like many preferred equities, have wide bid/ask spreads and can have low trading volumes. By using limit orders, investors can potentially get pricing below the ask price with a little patience. Market orders can lead to an immediate fill but at a higher price.
I personally hold Series J preferred shares and will be content if I receive my investment back plus a small premium if the shares are called in December. If the shares are not called, the dividends will continue to float at a premium to market rates. For Citi to eliminate its preferred dividend, it would need to first eliminate its common dividend and face more significant financial stress, similar to what occurred in February 2009, which is not the current scenario based on the bank’s financial data.
