Tobacco Sees Best Gain Since April After 17% Drop: Muni Credit

Photographer: Andrew Harrer/Bloomberg

In July 2012, Moody’s projected 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. Close

In July 2012, Moody’s projected almost three-quarters of the $20.4 billion in tobacco... Read More

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Photographer: Andrew Harrer/Bloomberg

In July 2012, Moody’s projected 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.

The $84 billion market for junk-rated tobacco bonds, one of the weakest areas of municipal debt this year, is rallying to a one-month high after a ruling against cigarette makers in a payment dispute with states.

Obligations from New York and Ohio, which account for about a third of high-yield tobacco debt, are leading the gains. Yields on 29-year New York City bonds backed by payments under a 1998 national settlement with cigarette companies fell to 7.76 percent on Sept. 13, the lowest in a month, data compiled by Bloomberg show. The extra interest rate on Ohio securities maturing in June 2047 dropped to a one-month low on Sept. 13, two days after the arbitrators’ findings.

Such securities have still lost about 14 percent in 2013, about three times the decline in the rest of the $3.7 trillion local-bond market, according to Barclays Plc (BARC) data. That pared the 2013 loss from 17 percent on Sept. 6. Only junk-rated water and sewer bonds have fared worse, falling almost 18 percent.

“For the states that won, clearly there should be improvement in the bonds,” said Richard Larkin, director of credit analysis in Iselin, New Jersey, at Herbert J. Sims & Co., which manages $2 billion of fixed-income. “What I worry about is people read too much into this and they apply it to all tobacco bonds when it’s not the case.”

Perpetual Funds

The tobacco bonds are joining the biggest muni rally since April, as investors are buying Illinois and California debt before the Federal Reserve’s two-day meeting beginning today.

Under the 1998 national settlement, Phillip Morris USA (MO), Lorillard Inc. (LO) and Reynolds American Inc. (RAI) agreed to make annual payments to the states in perpetuity to resolve their liability for health-care costs attributed to smoking.

Some states and cities borrowed against the payments, which are based on cigarette shipments. Most of the tobacco bonds assessed by rating companies are graded junk because of falling consumption and because the securities lack state backing. Including investment-grade debt, localities have sold about $97 billion of the securities, Bloomberg data show.

Arbitrators found last week that nine states “diligently enforced” state laws against tobacco makers that didn’t participate in the 1998 settlement between the companies and 52 states and jurisdictions. Six states lost in arbitration, according to Larkin.

Five of the nine states that won -- New York, Ohio, Illinois, Iowa and Washington -- have issued tobacco bonds and stand to recover more than $180 million withheld by the companies related to 2003 payments, according to news releases from the states’ attorneys general.

Default Delay

For issuers such as Nassau County, on New York’s Long Island, “this decision will definitely push back the date of a possible default for a good number of years, and may actually allow local issuers to pay 100 percent of their securitized tobacco debt in full and on time,” Larkin said in an e-mail last week.

Buyers demanded about 3.63 percentage points of extra yield to own the Ohio bonds on Sept. 13, the smallest yield spread since Aug. 13. The securities, issued by the Buckeye Tobacco Settlement Financing Authority, are rated B3 by Moody’s Investors Service, six levels below investment grade.

The tobacco companies have already paid states $62.5 billion, according to findings by arbitrators.

Level Field

Since the national settlement imposed significant costs to the tobacco companies that participated, states adopted laws assessing similar costs on cigarette makers that didn’t participate to level the playing field.

A dispute later arose between the major tobacco makers and the states about “diligent enforcement” of the statutes. As a result the tobacco companies have withheld more than $7 billion due to that states for the years 2003 to 2012.

In New York, the disagreement centered on the state’s policy of not taxing cigarette sales on Indian reservations. The state didn’t collect payments from companies that didn’t join the national settlement on reservation sales. The panel said there was no evidence to support the tobacco companies’ argument that New York arbitrarily decided to impose excise taxes and collect payments from sales of cigarettes on Indian reservations because it was state policy not to collect taxes on those sales.

The arbitration decision follows settlements over the disputed payments the tobacco companies have reached with 22 states and jurisdictions since December.

One Slice

The disputed funds represent about 10 percent of the annual payments to states, Richard Akulich, vice president of institutional sales and trading at Mesirow Financial Inc.’s muni department in San Francisco, said in an interview.

The added flow of money may still be overwhelmed by other risks to bondholders that could reduce the companies’ annual payments, such as declining cigarette consumption and tax increases at the federal, state or local level, Larkin said.

In July 2012, Moody’s projected 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. The average annual decline since 1999 has been 3.2 percent, according to Mesirow.

After the arbitration panel’s decision last week, the tobacco companies said they will pursue claims for the disputed 2004 payments against states that haven’t settled.

Arbitration Questions

“The arbitration rulings are positive for those states that have won, but there are a lot of questions about how future arbitrations proceed,” said Peter Bianchini, managing director at Mesirow.

Localities are set to sell about $4 billion in long-term debt this week at the lowest interest rates since August.

Benchmark 10-year munis yield 3 percent after extending their biggest weekly rally since April. The interest rate compares with 2.86 percent for similar-maturity Treasuries.

The ratio of the yields, a gauge of relative value, is about 105 percent, compared with an average of 93 percent since 2001. The higher the figure, the cheaper munis are in comparison.

Following is a pending sale:

Washington plans to sell about $295 million of federal highway grant-anticipation revenue bonds as soon as today to help finance a $4.1 billion bridge across Lake Washington, between Seattle and Redmond.

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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