Tobacco Rally Seen Slowing After 32% Gain Beats All: Muni Credit

Tobacco Rally Seen Slowing After 32% Gain Beats All
A worker carries a freshly picked load of flue-cured tobacco leaves in Kernersville, North Carolina. Photographer: Davis Turner/Bloomberg

High-yield municipal bonds backed by payments from tobacco companies under a 1998 settlement have earned 32 percent tax-free this year, beating all classes of state and local debt, according to Barclays Plc data.

In 2013, the rally is poised to slow, and investors may have to settle for the income they get from clipping coupons, said analysts such as Bart Mosley, co-president of Trident Municipal Research, a research company in New York.

Even as some bondholders get a boost from a $1.7 billion settlement this month between states and cigarette makers over disputed payments, the trend toward falling consumption remains.

“Buying tobacco bonds at this point is a little bit of a game of musical chairs,” said Mosley, a former head of municipal arbitrage trading at UBS AG. “You don’t want to get sucked into the good story now, because you’re liable to be the guy left standing when the music stops.”

Speculative-grade tobacco bonds are ranked below Baa3 by Moody’s Investors Service and under BBB- by Standard & Poor’s. The securities, which are gaining for a second-straight year, have benefited along with lower-rated assets across the fixed-income universe as Federal Reserve efforts to suppress borrowing costs pushed investors grasping for yield into riskier areas.

Liability Resolved

The $3.7 trillion muni market has returned 6.7 percent this year, while Treasuries have earned 1.9 percent, Barclays data show. Benchmark 20-year local-debt yields set a 47-year low of 3.27 percent Dec. 6, according to a Bond Buyer index.

The 1998 accord that 46 states struck with Phillip Morris USA, Reynolds American Inc. and Lorillard Inc. required the companies to pay more than $200 billion to resolve their liability in litigation over health costs related to smoking. Some of the states borrowed against the payments, which are based on cigarette shipments.

The high-yield muni tobacco-bond market is about $33 billion, data compiled by Bloomberg show. The total market, which also includes higher-rated bonds with state guarantees, is $100.5 billion.

The obligations have also rallied as cigarette-sale declines, spurred by a 62-cents-a-pack federal tax increase in 2009, have moderated. In 2011, the bonds returned 23 percent, according to Barclays. A credit-rating cut in 2010 led the segment to lose 22.1 percent that year.

$4 Billion

Last week, 17 states, the District of Columbia and Puerto Rico reached a settlement with Phillip Morris, Reynolds American and Lorillard over $4 billion in disputed payments the companies had withheld.

The companies that participated in the 1998 agreement had claimed they were losing market share to producers who didn’t sign on.

Under the agreement, settling states will get about $1.7 billion in proportion to their share of sales. The companies will get as much as $1.6 billion in credits on future payments. The deal requires approval by an arbitration panel.

“This pot of money that’s just been sitting there is getting dumped on bondholders,” said Troy Willis, a senior portfolio manager at OppenheimerFunds Inc. in Rochester, New York, which owns about $5 billion of tobacco bonds. “That’s going to make everything look better,” helping reduce yield spreads, he said.

Bond Rally

An Ohio tobacco bond maturing in June 2047 traded Dec. 20 for 89 cents on the dollar, to yield 6.7 percent, data compiled by Bloomberg show. On Nov. 22, 2010, it traded for 69 cents to yield 8.7 percent.

Cigarette-sale declines have slowed from 2009, when they fell 9.2 percent, and from 2010, when they dropped 6.4 percent, according to Janney Montgomery Scott LLC in Philadelphia.

Consumption fell 3 percent in 2011 and is set to drop an estimated 2.7 percent this year, said Willis. In the last decade, declines have averaged 3.6 percent, he said.

Six of the top 10 securities in Oppenheimer’s Rochester National Municipal Fund are tobacco bonds. The fund, with $6.9 billion of assets, has returned 18.2 percent this year, beating 98 percent of its rivals, data compiled by Bloomberg show.

While this month’s settlement is a boon for bondholders, the segment remains risky as cigarette use wanes, Mosley said. A cultural shift about the dangers of smoking and governments’ need to generate revenue means that cigarette sales are still subject to periodic shocks, Mosley said.

“The fact that consumption patterns have reverted to that long-term decline rate doesn’t give met that much comfort,” he said.

Default Forecast

In July, Moody’s Investors Service 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.

Bonds that have relatively long maturities and low cash reserves are among those vulnerable to lower smoking rates, Moody’s said. The company ranks almost 80 percent of tobacco bonds B1, four levels below investment grade, or lower.

While the settlement will increase the amount of cash available to pay debt service in 2013, the benefit will be short-lived, Richard Larkin, director of credit analysis at Herbert J. Sims & Co. in Iselin, New Jersey, wrote in a Dec. 20 report.

Tapping Reserves

Refunds due to the tobacco companies over the next five years almost equal the amount flowing to the settling states, according to Larkin.

That means states that agreed to the deal last week and had to tap debt-service reserves this year and last year to pay interest may have to do so again in 2014, he wrote.

“If nothing changes and no new states sign the agreement, cash-flow shortages and slower-than-expected turbo redemptions will continue to leave states like California and New Jersey with projected bond defaults in about 17 to 22 years” unless consumption picks up, he wrote.

In muni trading Dec. 24, yields on 10-year benchmark tax-exempts fell 0.01 percentage point to 1.8 percent, the first drop in a week, data compiled by Bloomberg show. The interest rate touched 1.81 percent last week, the highest level since Aug. 27.

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