PREPA Loan Deadline May Spur Sell-Off in Tobacco

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If the Puerto Rico Electric Power Authority were to fail to make loan payments to Citibank due on July 31, the consequences might spread beyond Puerto Rico bonds. Bad news on PREPA could also trigger a selloff of tobacco bonds, analysts speculated.

The two credits' performance is correlated because crossover buyers and yield-hungry municipal bond investors are generally large holders of the high yielding, low rated bonds. Investors are keeping a close watch how PREPA handles its bank loan deadline, concerned that problems meeting obligations to banks would be a step toward default on the authority's $8.7 billion of bonds.

When Puerto Rico bonds began selling off at the beginning of July, tobacco bonds yields followed in near tandem. Yields on PREPA 5.25s in 2040 which accounted for the most of PREPA's trading volume on Tuesday jumped 94 basis points to 13.89% on July 2, the Buckeye Tobacco Settlement Finance Authority's benchmark tobacco bond 5.875s in 2047's yield rose by 20 basis points to 7.97%, according to data provided by Bloomberg.

"I did hear of [tobacco bonds also selling off during the Puerto Rico sell-off] happening anecdotally," Dorian Jamison, municipal research analyst at Wells Fargo Advisors, said in an interview. "I would agree that that did seem to be the case that investors, funds that held both of those risky securities, were trying to get out of them."

When the PREPA 5.25s in 2040 began strengthening for the first time since the sell-off began on July 8 with yields dropping by 55 basis points to 13.87%, the benchmark Buckeye Tobacco bond's yields also lowered for the first time during the same period. The Buckeye Tobacco 5.875s in 2047 yields fell by five basis points to 8%.

Since June 27, the Friday before the yield hike on Puerto Rico debt began, to Tuesday the yield on PREPA 5.25s in 2040 increased by 11 basis points to 12.23%, and the Buckeye Tobacco 5.875s in 2047 rose by 17 basis points to 7.8%.

Puerto Rico bonds began selling off after the weekend of June 28 during which Puerto Rico Governor Alejandro Garcia Padilla passed a law that allows the commonwealth's public corporations to restructure their debt.

After the law was passed the three major rating agencies did mass rating downgrades on Puerto Rico and the commonwealth's organizations.

Puerto Rico officials have signaled that PREPA, which currently has $8.7 billion of outstanding debt, is the most likely of the commonwealth's eligible public corporations to restructure under the new Recovery Act.

So far in July PREPA has extended the $10 million line-of-credit payment that it had due to Citibank on July 3 to July 31, and announced on July 10 that its trustee had made an unscheduled withdrawal of $41.6 million from the debt service reserve to make bond payments scheduled on July 1.

PREPA owes Citi $146 million in total, according to Standard & Poor's.

J.R. Rieger, global head of fixed income indices at S&P Dow Jones Indices said in an interview that Puerto Rico events impacting tobacco bonds "may ring true."

"It's possible the retail investing community will react really negatively to monetary default [from PREPA to Citi]," he said. "It's very hard to predict but [if PREPA does default] their reaction might be to withdraw from bond funds."

Rieger said that if investors pull out of bond funds portfolio managers don't necessarily have to liquidate the Puerto Rico bonds.

"[Portfolio managers] may have to liquidate most liquid aspects of their portfolio, and [that may be] tobacco, because of its size, the tobacco bond deals are quite large," he said. "When you look at the high yield bond funds and what they own, Puerto Rico and tobacco make up largest portions of the S&P municipal high yield index."

He said that the market may see tobacco bonds being sold if PREPA doesn't make its payments to Citi on Thursday.

"Tobacco, which was a little bit more liquid than Puerto Rico at the time, is part of [the reason for the tobacco sell-off] you saw, and tobacco bonds were outperforming this year," Jamison said. "They were doing very well so I think some investors out there were taking profits. That they had outperformed too much, gotten so rich, investors were concerned they would see broader selloff like you saw with Puerto Rico."

The S&P Municipal Bond Tobacco Index shows that tobacco bonds have year-to-date returns of 10.84%. The S&P Municipal Bond Puerto Rico Index shows YTD returns of 4.37%.

Jamison said that if PREPA defaults it might affect tobacco bonds because Puerto Rico's performance is a strong influence over all high yield bonds.

"With what was happening to Puerto Rico and what we've said, those weaker credits tend to underperform once you start seeing [Puerto Rico] sell off in the market," Jamison said.

High yield municipal bond funds reported an inflow of $5.7 million for the week ending July 2, down from $217.3 million the previous week, according to Lipper FMI. The funds then reported a negative flow of $718.3 million for the week ending July 9, the first outflow reported in 25 weeks.

"Puerto Rico has influenced the broader muni market overall, even the high quality market," Anthony Valeri, CFA and senior vice president at LPL Financial, said in an interview. "When there was concern over PREPA in July, we had a couple weeks of outflows but it has been reversed."

During the week ending July 2 inflows for all municipal bond funds also declined, dropping by $214.14 million to inflows of $19.36 million

He said that is there is another scare on Puerto Rico, including a greater possibility of an issuer restructuring bonds, "the market could see the same reaction".

Other analysts do not predict that PREPA defaulting on its payments to Citi will impact tobacco bonds at all.

"I have no idea what it will do to tobacco bonds —that sector has its own set of problems…no correlation with PREPA other than both are high yield/ high risk," Richard Larkin, senior vice president and director of credit analysis at HJ Sims & Co, wrote in an email.

Jamison said the correlation between Puerto Rico and tobacco bonds is indirect.

"I don't know that it would be a direct correlation, but I would say as we saw earlier that any general weakness in the high yield sector could have, could impact rest of high-yield sector including tobacco," he said. "So I would not be surprised if [Puerto Rico bonds performing badly] similar impact [on tobacco bonds] as we saw earlier in the summer."

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