CHICAGO — The Illinois Railsplitter Tobacco Settlement Authority hopes to sell investors on its $1.46 billion tax-exempt tobacco bond issue early next month by using a more conservative structure than seen on past deals that ensures bondholders are repaid even if cigarette consumption falls annually by 10% in the coming years.
The deal — which will raise about $1.3 billion to pay off a state backlog of fiscal 2010 bills — is set for a Dec. 1 pricing. It’s the first by Illinois to securitize the state’s share of payments under the 1998 Master Settlement Agreement between 46 states and most major tobacco companies. It is the first tobacco bond sale in more than two years from a sector battered by cigarette consumption declines, lawsuits, rising taxes, downgrades, and default warnings.
State debt manager John Sinsheimer described the issue as unique compared to past tobacco issues, and several market participants agreed. The structure is designed to cater to investors who may be wary of the headlines over looming tobacco defaults.
“This is a very different bond in the tobacco space,” he said in an interview Friday. “It’s a very strong credit structure. Every aspect of this deal was structured conservatively to make this attractive to investors. We want this deal to be successful, as it’s a very important part of our budget.”
The issue drops the turbo redemptions, super-sinking funds and capital appreciation bonds popular in past issues in favor of a more traditional tax-exempt structure that offers a mix of serials and term bonds limited to a 17-year maturity. It also provides a significant cash cushion in debt-service coverage ratios and a reserve will be funded at $146 million.
Citi is the book-runner and Barclays Capital is co-book-runner. Public Financial Management Inc. is financial adviser on the sale. Nixon Peabody LLP is bond counsel. The Bank of New York Mellon Trust Co. is trustee. Jefferies & Co., JPMorgan, and Morgan Stanley are co-senior managers. Another six firms round out the underwriting team as co-managers.
The bonds are backed solely by the state’s share of its payments under the MSA, from which Illinois received $284 million this year and expects to receive $305 million next year. Under the settlement agreement, the state was to receive $9.1 billion through 2025, but actual payments depend on a complex formula adjusted for the size of the cigarette market, inflation, consumption, and other factors.
The Railsplitter authority, created by Illinois for the purpose of this transaction, will purchase all of the state’s assets from the agreement and all payments are pledged to bondholders. The deal securitizes 45% of those assets.
The issue offers bonds with serial maturities between 2012 and 2015 of $51.76 million each and of $104.42 million from 2016 through 2021. There are term bonds of $313.2 million in 2024 and 2027 with three-year sinking fund installments on each of the term bonds.
“It’s a very conservative structure. If you are going to sell tobacco bonds in this market, this is the way to do it,” said Dick Larkin, director of credit analysis at Herbert J. Sims & Co. Larkin earlier this year warned that the shrinking pool of smokers puts billions of dollars of bonds backed solely by MSA payments in jeopardy of default as soon as 2030. He said at the time that future issues would need to offer shorter maturities and strong cash-flow coverage to avoid steep pricing penalties.
“There’s more cash-flow cushion here to pay bonds than we’ve seen in any other tobacco bond issue,” Larkin said. The tobacco companies paid states $6.39 billion this year under the MSA, down from the $8.14 billion original base estimate in the agreement. That forced some states to reduce the accelerated repayment of some bonds with turbo redemption structures.
Fitch Ratings assigned its highest tobacco rating, a BBB-plus, to the Railsplitter issue. It is one notch higher than the agency’s view of the overall sector. “It’s a straightforward structure,” said Fitch analyst Cynthia Ullrich.
The state was still waiting for a rating from Standard & Poor’s.
Under various stress scenarios outlined in the offering statement, if consumption falls annually by 4%, available payments would provide a minimum 1.72 times coverage ratio in 2016 and rise to 2.55 times in 2027. Under that scenario, the state would collect a total of $4.9 billion in settlement payments over the life of the bonds, with $2.2 billion going to repay the debt.
Under a 7% decline, debt-service coverage hits a low of 1.48 times in 2016 and ends at 1.60 in 2027. The break-even point comes in a scenario envisioning a 10.04% annual dip in tobacco consumption in which debt service hits one times in 2027 with total payment collections at $3.2 billion.
Consumption declined by 9% last year and is expected to decline by another 6% this year. Many past tobacco issues assumed a 4% decline.
If the state fails to make sinking fund payments, an event of default occurs. Under many previous structures, such a failure would not trigger a default. With strong coverage ratios, however, it is unlikely sinking fund payments would not be made, Larkin said.
Illinois will compete for investors facing a wealth of mostly Build America Bond offerings in the coming weeks. The state can’t put off the deal until supply ebbs next year, when the BAB program in its current form will have expired, because of its dire cash-flow situation. Proceeds of the sale are needed to help pay off fiscal 2010 bills. The state currently has a backlog of $5.7 billion of bills dating back to March, according to state Comptroller Dan Hynes.
The emergency budget act approved earlier this year extended the deadline to December to pay off previous fiscal year bills. The tobacco sale was among the nonrecurring revenues lawmakers turned to in order to deal with a $12 billion deficit in 2010 that contributed to a series of downgrades.
Sinsheimer today will meet with potential investors in Boston. Other meetings have been held or are scheduled in Chicago, Los Angeles, New York City, and San Francisco. Officials hope the conservative structure and marketing effort will help limit pricing penalties attached to most securities from the state — even those with no direct reliance on the state’s general fund for support.
Tobacco settlement funds needed to cover debt service will flow first to the trustee, with residuals not needed for debt service going back to the state to cover the costs of programs currently being funded with tobacco payments.
The offering statement spells out the warnings associated with tobacco issues and the impact of taxes, lawsuits, and the economy on consumption rates that affect the size of MSA payments. It notes that the tobacco industry is a defendant in 11,200 lawsuits. Consumption hit a high of 640 billion cigarettes in 1981. Since last year, consumption has fallen off 9.3% to 325 billion. It has declined 4.3% annually over the past five years.
