Tobacco-Bond Woes Seen as Chicago Seeks Highest Tax: Muni CreditBrian Chappatta
Mayor Rahm Emanuel’s plan to make Chicago cigarette taxes the nation’s highest is the latest blow to tobacco bonds, the weakest revenue-backed municipal debt of the past three months.
Buffeted by tax increases, stricter regulation and e-cigarettes that deliver nicotine without smoke, the securities have earned about 0.1 percent since the end of July. That’s less than the broad market’s 1.4 percent gain and the weakest of 11 types of revenue bonds tracked by Barclays Plc. Tobacco obligations from New York to California have trailed the $3.7 trillion municipal universe, with yield spreads reaching the widest since February.
Emanuel this month proposed raising the cigarette tax by 75 cents in the third-most-populous U.S. city, which faces a budget deficit of $339 million. The 50 percent increase, to $7.42 per pack, would move Chicago ahead of New York as the U.S. metropolis with the steepest cigarette taxes. Higher levies can curb sales, reducing the payments that states get from tobacco companies and use to back securities.
Tobacco bonds were bought and sold “with the assumption that consumption was inelastic,” said Jim Schwartz, head of muni research at New York-based BlackRock Inc., which oversees about $108 billion in local debt. Investors “never expected this level of taxes,” he said.
Some localities mending their finances after the 18-month recession that ended in 2009 have turned to levies dubbed sin taxes, on sources such as cigarettes, alcohol and gambling. U.S. cities project their first revenue increase since 2006, according to the Washington-based National League of Cities.
Under a 1998 national settlement, Philip Morris USA, Lorillard Inc. and Reynolds American Inc. agreed to make annual payments to states in perpetuity to resolve liabilities for health-care costs. Some states and cities borrowed against the payments, which are based on cigarette shipments. Localities have sold about $97 billion of the securities, data compiled by Bloomberg show.
Most tobacco bonds assessed by rating companies are graded junk. Speculative tobacco debt has lost about 10 percent this year, second-worst among 13 high-yield segments of the market, Barclays data show.
In July 2012, Moody’s Investors Service projected almost three-quarters of the $20.4 billion in tobacco bonds it grades will default if consumption declines as much as 4 percent annually.
The Congressional Budget Office estimates a 10 percent increase in cigarette prices will reduce smoking by at least 3 percent. U.S. cigarette shipments have averaged annual declines of about 4 percent since 1997, according to Richard Larkin, director of credit analysis at Herbert J. Sims & Co.
“Consumption continues to decline, and these bonds are only secured by domestic cigarette consumption,” said Tom Metzold, co-director of muni investments in Boston at Eaton Vance Management, which oversees about $28 billion in local debt. He said he emptied his company’s national muni fund of tobacco bonds.
“There will be bonds that default over the next five to 10 years. There’s no question about it,” Metzold said.
Tobacco bonds from coast to coast traded this month at levels that show investors’ concern.
Tax-exempt debt issued by New York’s TSASC Inc., an entity set up to sell the tobacco bonds, and maturing in June 2034 traded Oct. 15 at an average yield of 9.49 percent, Bloomberg data show. For top earners, that’s equivalent to a 15.7 percent taxable interest rate. In comparison, junk-grade company debt of a similar maturity yields about 7.1 percent, Bank of America Merrill Lynch index data show.
Similarly, relative borrowing costs have risen on tax-free securities due in June 2047 from California’s Golden State Tobacco Securitization Corp. The debt traded with a yield that was 3.91 percentage points above benchmark munis Oct. 10, the widest gap since at least February.
Citigroup Inc. strategists, including George Friedlander and Vikram Rai, said in an Oct. 25 report that tobacco bonds were “hit especially hard” in this year’s muni selloff because of changes to the industry. That presents “an attractive opportunity,” they said.
The outlook isn’t all bleak for bondholders. Companies’ payments to states rise by at least 3 percent a year to account for inflation, which has helped offset cutbacks in smoking, said Alan Schankel, managing director at Janney Montgomery Scott LLC in Philadelphia.
Even though issuers may fail to make timely debt-service payments, bondholders will eventually be repaid because the cash flows have no end date, Schankel said.
In Chicago, the proposal would boost the cost of a pack of Marlboros at a south Loop convenience store to $12.70 from $11.95. The city already has an ordinance banning smoking in almost all enclosed public places and prohibits lighting up within 15 feet (4.6 meters) of their entrance.
The mayor’s budget projects $25.9 million from the tax in 2014, up from $16.5 million this year, according to Kelley Quinn, his spokeswoman. Revenue from the increase would go toward enrolling 15,000 public-school students in Medicaid, Emanuel said in an Oct. 23 presentation.
The city council has to approve the plan, which is part of the mayor’s budget proposal. It would take effect Jan. 1.
Smoking bans such as Chicago’s have helped spur consumption of e-cigarettes, which emit water vapor instead of smoke, allowing them where traditional cigarettes are prohibited.
Fitch Ratings said in September that e-cigarette use may increase as much as 50 percent in the next year. Bloomberg Industries projects global e-cigarette purchases could surpass traditional cigarette sales by 2040.
“It’s a risk that was never modeled in,” said BlackRock’s Schwartz.
In the municipal market this week, issuers from Connecticut to Arizona are set to offer about $4.6 billion in long-term debt with benchmark yields at a four-month low.
The interest rate on AAA 10-year munis is 2.66 percent, the lowest since June 21, Bloomberg data show. That compares with 2.5 percent on similar-maturity Treasuries.
The ratio of the yields, a gauge of relative value, is about 106 percent, compared with an average of 94 percent since 2001. It has been above 100 percent since June 24. The higher the figure, the cheaper munis are compared with federal securities.
Following is a pending sale:
Hawaii plans to sell about $852 million in general-obligation bonds next week, Bloomberg data show. Proceeds will refinance debt and pay for projects authorized by lawmakers.