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Tobacco Debt Beating Market Seen Losing on Tax Rise: Muni Credit

Tobacco Debt Beating Market Seen Losing on Tax Rise
Workers pick flue-cured tobacco leaves during the harvest in Kernersville, North Carolina. Photographer: Davis Turner/Bloomberg

Tobacco bonds, which beat every group in the $3.7 trillion municipal market from October through March, are now falling behind as President Barack Obama’s plan to boost cigarette taxes threatens payments backing the debt.

The president proposed raising the per-pack federal tax on cigarettes by 94 cents, to $1.95, to finance a pre-kindergarten program, the administration said yesterday in its 2014 budget recommendation. That jump would cut consumption by about 12 percent, according to Kenneth Shea, senior tobacco analyst at Bloomberg Industries.

About $101 billion of municipal debt is backed by payments tobacco companies make to states as part of a 1998 settlement, based on annual cigarette shipments. Such debt has earned 0.3 percent in April, trailing a 0.7 percent gain in the broader market, Bank of America Merrill Lynch data show. Less smoking means less money to repay debt, raising the risk of owning the securities, said Richard Larkin, director of credit analysis at Iselin, New Jersey-based Herbert J. Sims & Co.

An enacted tax is “going to whack tobacco bonds,” said Larkin, who’s based in Boca Raton, Florida, and smokes 10 cigarettes a day, down from three packs 30 years ago. “It just reinforces the fact that the environment to tax cigarettes higher and higher continues.”

Yield Draw

Tobacco bonds have drawn buyers with their higher yields compared with benchmark munis as interest rates remain below historical averages. Twenty-year general-obligation bonds yielded 3.96 percent last week, below a 52-year average of 5.88 percent, according to Bond Buyer data.

Tobacco debt has still earned 3 percent in the past six months, more than the 1.5 percent gain for the whole muni market and beating other revenue-bond categories, according to Barclays Plc data.

Increasing cigarette prices “puts that type of performance going forward at risk,” said Alan Schankel, head of fixed-income research at financial services firm Janney Montgomery Scott LLC. in Philadelphia.

The president’s proposal is drawing the attention of Louisiana, which plans to refinance tobacco bonds.

Louisiana Looking

“A potential tax increase actually makes it all the more important to act now to secure these savings for the state,” said Michael DiResto, an assistant commissioner in the Division of Administration, said in an e-mail.

Congress last raised the tax by 62 cents to $1.01 per pack in April 2009, according to Shea. Following that, consumption fell about 9.5 percent in 2009 and more than 6 percent in 2010, Schankel said. The segment hasn’t had a negative annual total return since 2010, Bank of America data show.

The average price in the U.S. last year for a pack of smokes was $6.20, and it would rise as high as $8 if the Democratic president’s tax plan were enacted, Shea said.

Debt sold by New Jersey’s Tobacco Settlement Financing Corp., the most frequently traded tobacco bonds last year, has seen yield spreads rise from a week ago, using BVAL pricing analysis. Securities maturing in June 2041 were valued at a spread of 2.6 percentage points yesterday, compared with 2.5 percentage points a week earlier, BVAL data show. The bonds are rated B- by Standard & Poor’s, six steps below investment grade.

Still, in a sign of the rally in this segment, the spread was above 3 percentage points in October.

Industry Payments

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 states borrowed against the payments, which are based on cigarette shipments.

Bryan Hatchell, a spokesman for Winston-Salem, North Carolina-based Reynolds American, said last week that Obama’s plan would raise taxes on low- to middle-income Americans.

While many lawmakers in Congress oppose tax increases, it’s possible that legislators may pass this one, Larkin and Schankel said. Some see cigarette taxes as helping smokers quit, and the extra revenue would go to “a very good cause,” Larkin said.

“Even though the current Congress is anti-tax, taxes on cigarettes are looked at as mom and apple pie,” said Larkin, who lit his first cigarette on his first day of work at S&P analyzing municipal credit in 1975.

Meantime in the municipal market, California wraps up a $2 billion general-obligation sale today, part of the biggest wave of sales this year, Bloomberg data show.

Munis are still rallying relative to Treasuries as selling related to tax season wanes. Ten-year benchmark munis yield 1.82 percent, a five-week low, Bloomberg data show. Treasuries of a similar maturity yield 1.8 percent.

The ratio between the two interest rates, at about 101 percent, has dropped from a seven-month high of about 113 percent set April 5. The lower the percentage, the more expensive local debt is by comparison.

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