Tobacco Bonds Face Default as Smoking Declines, Moody’s Says

The declining number of U.S. smokers is proving hazardous to the health of municipal bonds backed by payments from cigarette companies under a 1998 settlement with 46 U.S. states, Moody’s Investors Service (MCO) said.

The rating company projected that almost three-quarters of the $20.4 billion in tobacco bonds it grades will default if cigarette consumption declines 3 percent to 4 percent annually.

Tobacco bonds that have a high ratio of outstanding debt to annual payments from the companies, long maturities and low cash reserves are vulnerable to lower smoking rates, Moody’s said today in a report. Moody’s rates almost 80 percent of tobacco bonds B1, which is four levels below investment grade, or lower.

“Some of them have very high leverage,” with ratios of debt to annual payments of 16 to 18 times, said Irina Faynzilberg, a Moody’s analyst who co-wrote the report.

Payments by Altria Group (MO) Inc.’s Philip Morris unit, Reynolds American Inc. (RAI) and Lorillard Inc. (LO) to states under the settlement back $101.5 billion of bonds, according to data compiled by Bloomberg.

Payments to states, which are based on U.S. cigarette sales, rose almost 2 percent this year, according to Mesirow Financial Inc. Sales declines of 2.9 percent in 2011 were offset by an inflation adjustment and growth in market share from companies participating in the settlement.

One in Five

Cigarette use fell 9.2 percent in 2009 and 6.4 percent in 2010, according to Janney Montgomery Scott LLC, a Philadelphia- based brokerage. About one in five Americans smoke, according to the U.S. Centers of Disease Control and Prevention.

Virginia, California and Nassau County, New York, may use reserve funds to pay debt service on three tobacco-bond issues from 2006 and 2007, Mesirow said in May.

Tobacco bonds have earned 4.26 percent this year through June 30, compared with 4.1 percent across the $3.7 trillion municipal market, Bank of America Merrill Lynch indexes show.

Moody’s projected that 33 percent of the tobacco bonds it rates can’t withstand annual consumption declines of 2 percent to 3 percent, while 41 percent of the debt couldn’t handle declines of 3 percent to 4 percent.

More-recently issued tobacco bonds have been structured by banks to withstand consumption declines of as much as 10 percent.

To contact the reporter on this story: Martin Z. Braun in New York at mbraun6@bloomberg.net

To contact the editor responsible for this story: Stephen Merelman at smerelman@bloomberg.net

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