Could Tobacco Bonds Go Up In Smoke?

Backed by a $206 billion settlement, they still carry risks

Tobacco bonds. They don't exactly sound like securities you would want to have in your portfolio. But on Nov. 1, investors snapped up some $709 million worth, the first such deal ever floated. Indeed, the issue was sold out, leaving many empty-handed.

The deal was part of the 1997 settlement of the huge smoking-related litigation. Over the next 25 years, the tobacco industry will dole out about $206 billion to 46 states, which will divvy it up among their counties. The money will come from companies such as R.J. Reynolds, Philip Morris, Brown & Williamson, and Lorillard Tobacco as well as 19 smaller tobacco manufacturers.

New York City, which consists of five counties, was the first municipal government to cash in on its share by securitizing the money it is owed by the tobacco industry. Securitization means selling the rights to future cash flows for an up-front lump sum payment.

New York had the choice of collecting its share, $6.5 billion, over the next 25 years, or getting some cash up-front by using the flow of cash from the tobacco companies to collateralize the bonds, which pay investors interest and principal. The city opted to collect about $2.5 billion over the next four years by floating four bond issues. The tax-free offering was underwritten by Salomon Smith Barney.

HIGH RATINGS. Bankers expect dozens of securitizations of tobacco revenues across the U.S. More than 90% of New York City's paper was bought by large institutions like Fidelity Investments and Dreyfus for yields ranging from 4.2% to 6.4% depending on maturity. The highest ratings ranged from Standard & Poor's AA- to Moody's Investors Service's AA1. Despite investor appeal and relatively high ratings, the tobacco bonds are not without risks. Suing tobacco companies now seems as natural as taking a drag on a cigarette. But a class action in Florida and a federal lawsuit winding their way through the courts make some industry observers wonder how many multibillion-dollar hits tobacco companies can keep taking without an effect on their solvency. Of particular concern are the damages currently being assessed in the Florida suit, which could range in the hundreds of billions. If the tobacco companies are required to post a bond for these damages, it could force them into bankruptcy.

"You can't quantify litigations down the road, and you can't quantify future consumption of tobacco," says Bruce MacLean, managing director of Hartford Investment Management, which manages $10 billion in municipal bonds for clients. Hartford Management chose not to participate in the New York City securitization.

There's still another risk to the issue's viability. States must use tobacco revenues to educate the public on the risks of smoking. If the campaign is effective, it could decrease the number of smokers. That in turn would lower the tobacco payments owed to the states, since the deal is pegged to the amount of cigarettes sold.

Many investors simply recoil from being associated with cigarettes and the health costs they produce. "That's why as an insurance company we won't be investors," says Steven Tompson, managing director at Prudential Structured Finance Group in Newark, N.J.

But worries over the health of tobacco companies have been blown out of proportion, say some analysts. "Certainly, the market is concerned right now that tobacco stocks could go bankrupt," says Bonnie Herzog, a tobacco analyst for Credit Suisse First Boston in New York. "But I think that's unrealistic, given that I do not believe these companies will be required to post a bond. Ultimately, I think the Florida case will be dismissed."

Meanwhile, New York City plans to float three more tobacco issues in the next four years. Public schools and the police department will be some of the early recipients of the cash. New Yorkers should hope cigarette smokers don't quit anytime soon: After all, smoking may cause cancer, but cigarette sales may also help Johnny read.

Before it's here, it's on the Bloomberg Terminal.