The Ebola virus is back, and it brings with it other unpleasant memories of the 1990s. As you may recall, that decade was marked by two major bond market debacles, one in 1994, the other in 1998. Risk assets, particularly the high yield sector, did not fare well in those two instances. No wonder high yield corporate bond investors have become very nervous about credit spreads hitting a cyclical low even as the Federal Reserve starts to wind down its massive stimulus program.
A global health scare does have a way of putting things in perspective, to be sure. Hundreds of Africans have lost their lives in the latest outbreak. Yet, here we are, biting our nails about such mundane things as the fate of the Puerto Rico Electric Power Authority (PREPA), which is probably being decided at this very moment.
In terms of PREPA, most market participants have probably already made their bet by now and are in wait-and-see mode. That said, volatility could certainly rise as we get closer to the next bank line rollover date, August 14th. Interestingly, the Bond Buyer yesterday reported an “explosion” in trading volume for PREPA 5.00% in 2042, to $23.03 million from just $3.28 million on Monday. Although $23 million was nothing to scoff at, it is still quite a modest number and we would hardly call that “explosive.” It is, after all, August and we’re well into the dog days of summer.
The paper also reported that traders were concerned about PREPA’s price slipping to 48.75 on Tuesday from 48.875 at the beginning of the week. Since when is 1/8 of a point move considered significant, particularly in a volatile sector like Puerto Rico? Tuesday must have been a slow news day.
New Issue Market
On the new issue front, the deal of the week is without question the $607 million tobacco bond issue from the State of Rhode Island’s Tobacco Settlement Financing Corporation. Proceeds will go to: (1) refund all the outstanding Series 2002 bonds and part of the Series 2007, (2) tender for some of the Series 2007 notes and (3) generate an upfront cash payment of about $20 million to the State.
The deal will come in two tranches, a $336 million current interest Series 2014A and $271 million current interest Series 2014B with a turbo redemption feature. In keeping with its current practice of rating shorter maturities higher than longer ones, given the declining long-term outlook for tobacco shipments, S&P rates the 2014A Series “A” through 2024, “A-” from 2025 to 2034 and “BBB+” for the 2039 maturity.
The component of the transaction that brought to mind last April’s New Jersey tobacco deal is the fact that the State offered to buy out some of the Series 2007 bonds, primarily subordinate capital appreciation bonds. Might this be another bailout of the bondholders at the expense of taxpayers?
From what we can gather from media reports, the Rhode Island transaction appears more justifiable from a public policy standpoint than the one done by New Jersey. The New Jersey transaction stood out for its fiscal short-sightedness (which we discussed in an earlier column, “Tobacco Bonds and Fiscal Gimmickry“) and it was purely designed to get the Christie Administration some much-needed upfront cash. In the process, the Garden State also bailed out some of the capital appreciation bonds (CABs) that were already heading for default.
The Rhode Island deal may accomplish much more than just getting the State some upfront cash. The Financing Corporation needed to get approval from a majority of the Series 2007 CABs to effect a current refunding of the 2002 bonds. As it so happens, the current majority holder of the 2007A Series had a low cost basis on their bonds, having purchased them at distressed levels from the original mutual fund holder during the financial crisis. This allowed the Corporation to buy out such majority holder at a substantial profit while obtaining the authority to do the refunding. The remaining 2007 CABs who did not tender should still see an improvement in the underlying credit and better liquidity, all other things equal.
By tendering for the CABs, the State will be retiring a significant future liability of about $700 million. The new 2014 indenture also allows the release of monies from the Tobacco Disputed Payment account for the benefit of the State.
The Series 2002 bondholders may be the only party that might not be happy with this deal, as they will lose their bonds at par, along with the attractive coupon income. Some of them may be forced to re-invest in the Series 2014.
To make matters even more interesting, the Oppenheimer Funds has filed suit against the RI Tobacco deal, claiming the transaction “violated State law and the Corporation’s obligation to current bondholders, including our funds, whose investments allowed the State to collect much needed cash by monetizing its anticipated future payments from the tobacco companies.”
… one topic that probably deserves greater scrutiny is the fact that many states will have to deal with billions of back-loaded tobacco bond exposure from capital appreciation bonds.
Apparently, what’s stuck in Oppenheimer’s craw is the fact that the State is taking out $20 million even while subordinating the Series 2007 bonds (those still outstanding) to the new 2014 issue. While we applaud the firm’s strong stance on behalf of its shareholders, we would point out that Oppenheimer was reportedly among those bondholders who got a significant windfall from the earlier New Jersey deal. I guess it’s all a matter of perspective.
Pricing-wise, the early price talk that was circulated on Monday was aggressive, but certainly not surprising given the current dearth of yield supply. For instance, for the 2039 maturity, rated only BBB+ by S&P, the underwriter proposed a coupon of 5.00% to yield 4.864% to maturity, or +150 versus AAA. Clearly, one has to take a deep breath before buying a “high yield” name with a 4 percent handle, but such is the current state of the market.
Not surprisingly, the aggressive price level has run into a bit of resistance from potential buyers and Citigroup as underwriter has reportedly placed the deal on “day-to-day” status. While we’re in no position to comment on the merits of the Oppenheimer suit, we do believe it will get resolved and the deal will get done, hopefully at more attractive levels.
Incidentally, one topic that probably deserves greater scrutiny is the fact that many states will have to deal with billions of back-loaded tobacco bond exposure from capital appreciation bonds. At some point over the next three decades, we may have a confluence of cigarette sales declining to low levels even as the massive liabilities from the CABs come due. It would be interesting to see if states across the nation will actually let those bonds default. Rhode Island is certainly getting in front on that potential policy headache by dealing with it now. Other states should take heed.
From the State of Rhode Island’s standpoint, the timing of this refunding could not be better. However, as an investor, you still need to decide whether you want to participate at all at this juncture in the market. At least for now, it’s still a seller’s market.
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