More than $15 billion of municipal bonds backed by tobacco-company payments will default within 30 years, Moody’s Investors Service says. That’s not deterring investors from reaping the best returns in the tax-free market.
Tobacco bonds rated below investment grade have earned 17.1 percent this year, according to Barclays Plc total-return indexes. That compares with 4.8 percent for the rest of the $3.7 trillion muni market.
The securities depend on payments to the states under a 1998 health-care settlement between 46 attorneys general and major tobacco companies. Investors confronting the lowest yields since the 1960s have poured $4.7 billion this year into high- yield muni bond funds.
“A default doesn’t mean they’ll go to zero,” said Daniel Solender, who helps manage $17 billion of muni debt, including about $500 million of tobacco bonds, at Lord Abbett & Co. in Jersey City, New Jersey. “There is a demand for credit risk.”
Payments to states under the settlement back $101.2 billion of bonds, data compiled by Bloomberg show.
Speculative-grade tobacco borrowings have rebounded from 2010. Credit-rating cuts and a municipal-market selloff spurred by a flood of local bond sales and predictions of widespread defaults led the tobacco segment to lose 22.1 percent that year, according to Barclays. In 2011, high-yield tobacco returned 23 percent.
Tobacco bonds typically mature in 20 years or more, making their prices more sensitive to changes in yields than shorter- term issues. As a result, the securities got an outsized boost as the Federal Reserve’s purchases of longer-term debt pushed down interest rates and as investors fled to the safety of Treasuries and munis.
“Tobacco was a beaten-up sector and there’s been some decent news,” said Tom Weyl, director of municipal research at Barclays in New York. “In a rally of the entire marketplace, many times you see the formerly worst-performing sector has the most to come back.”
Payments to states by Altria Group Inc. (MO)’s Philip Morris unit, Reynolds American Inc. (RAI) and Lorillard Inc. (LO), rose almost 2 percent this year to $6.15 billion, according to the National Association of Attorneys General. The payments are based on the volume of U.S. cigarette shipments. Declines of 2.9 percent in 2011 were offset by an inflation adjustment and growth in market share from companies participating in the settlement.
Cigarette-sale declines have moderated from 2009, when they fell 9.2 percent, and 2010, when they declined 6.4 percent, spurred by a 62-cents-a-pack federal tax increase in 2009, 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.
Tobacco bonds also got a boost two weeks ago when President Barack Obama signed a highway bill that included a provision taxing roll-your-own machine-made cigarettes at the same rates as packaged ones.
An Ohio tobacco bond with a 5.875 percent coupon maturing in 2047 traded July 18 at an average of 78 cents on the dollar for a tax-exempt yield of 7.7 percent. On Jan. 4, the bonds traded at 70.3 cents with an 8.5 percent yield.
Tobacco bondholders have a claim in perpetuity on revenue from the 1998 settlement that was pledged to back bonds.
If a bond reaches maturity and there isn’t enough cash to pay principal, the debt extends and investors are entitled to receive future settlement revenue, Dan Loughran, a portfolio manager with OppenheimerFunds Inc., said at the State & Municipal Finance Conference hosted by Bloomberg Link in June.
The scenario is “a far different risk than, say, a credit risk where you have an unsecured bond that files for bankruptcy and you’re looking at 10 cents on the dollar in recovery,” he said at the conference in Chicago.
Last week, Moody’s 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. Moody’s rates almost 80 percent of tobacco bonds B1, which is four levels below investment grade, or lower.
More-recent tobacco issues have been structured to withstand consumption declines of as much as 10 percent and carry higher ratings. A bond maturing in 2037 issued by Suffolk County, New York, in April traded on July 6 at a 4.7 percent yield. The bond is rated BBB+ by Standard & Poor’s, its third- lowest investment-grade rating.
Richard Larkin, director of credit analysis at Herbert J. Sims, said consumption declines will be greater than 4 percent as more cigarette tax increases and anti-smoking ordinances are adopted.
“Even if you have ’em you can’t smoke ’em because it’s basically being made illegal in every place,” Larkin, a smoker, said at the Link conference. “The long-term trend for decline, I don’t think it’s going to get better; it’s going to get worse.”
Another cloud hanging over investors is a more than two- year arbitration between the states and the tobacco companies that participated in the settlement over whether the states have sufficiently enforced the 1998 accord.
The companies are seeking refunds from states on the grounds that the governments didn’t diligently enforce statutes related to smaller producers that weren’t part of the settlement.
More than 30 states and localities that issued bonds backed by settlement payments are at risk of losing $1.1 billion if arbitrators decide they didn’t adequately enforce the agreement, said Larkin, who follows tobacco bonds for Sims & Co., which is based in Iselin, New Jersey.
“Some states might take a real beating in terms of losing future revenues under the settlement,” Larkin said. “I call it cigarette roulette.”
Following are pending sales:
MARYLAND, with a top credit rating, plans to sell about $728 million of general obligations as soon as next week, according to Fitch Ratings. The state plans to offer $75 million of tax-exempt bonds via negotiated sale on July 27 and July 30, and $653 million via competitive sale Aug. 1, according to Fitch. (Added July 20)
LOS ANGELES DEPARTMENT OF WATER & POWER plans to sell about $413 million of revenue bonds as soon as next week, according to data compiled by Bloomberg. Proceeds will refund debt and fund capital improvements, according to an offering statement. Moody’s rates the debt Aa2, the third-highest level. (Updated July 20)
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