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Tobacco Debt Still Has Some Spark

Tobacco bonds have been on the defensive for several years now as the number of smokers dwindles. But for some yield-addicted investors, tobacco bonds are now seen as a buying opportunity despite their risks.

Most tobacco bonds are backed by payments made under the 1998 Master Settlement Agreement that requires tobacco manufacturers to make annual payments to states and other municipalities based on consumption. The past two years have seen drastic consumption declines that rating analysts say will force issuers to dip into reserves to make bond payments.

The highest rating assigned by Fitch Ratings in the tobacco sector is now BBB-plus, with about 30% rated in the non-investment-grade category. The rating agency last month downgraded several tobacco bond issues to B or BB from BBB. Now, only about 69% are rated in the triple-B category, followed by 16.27% in the double-B category, and 14.68% in the single-B category.

Cynthia Ullrich, senior director in Fitch's asset-backed securities group, said the BBB-plus cap on the sector is due to lower MSA payments that in large part have resulted from declining consumption.

Last November, Standard & Poor's dropped the ratings on almost half its tobacco bonds to junk level. That action spooked investors and helped stoke a sell-off in municipal bond funds.

Despite the negative rating reviews, investors have been bidding prices higher for the downgraded bonds and many are trading with yields near calendar-year lows.

"Rating agencies are being ignored more and more in the financial markets, given their performance," said Dan Loughran, who heads the Oppenheimer Rochester municipal investment team as a senior portfolio manager of OppenheimerFunds Inc., which buys tobacco bonds for 18 of its 21 municipal bond funds. "So to tie actual market moves to a rating change is much less relevant now than it was years ago. Tobacco bonds as a high-yielding bond are impacted by the general changes in credit spreads in the muni market."

Bonds issued by Ohio's Buckeye Tobacco Settlement Financing Authority in 2007 with a 2024 expiration saw yields drop to 2011 lows of 7.24% in the last weeks of July, sliding 114 basis points from a high of 8.38% in January, according to Municipal Market Data. At the end of July, the bonds were downgraded by Fitch to B-plus from BBB-minus with a negative watch. The bonds are now trading with yields of 7.94%.

Ullrich said the Ohio bonds are currently on negative watch due to the expectation that the reserve account will be drawn below its minimum after December payments.

The California County Tobacco Securitization Agency issued Los Angeles County Securitization Corp. convertible turbo bonds in 2006. The 2021 bond hit a high of 6.87% in January and dropped 47 basis points to a low of 6.4% in late July, according to MMD. The bonds were downgraded by Fitch to B-plus with a negative outlook from BBB-plus, and are trading at about 6.67% now.

Golden State Tobacco Securitization Corp. turbo term bonds set to expire in 2027 were recently downgraded by Fitch to BB from BBB and put on negative watch. In January, the bonds hit a high of 7.71% and dropped to a low of 5.99% in late July, sliding 172 basis points, the MMD scale shows.

BondDesk Group, which monitors retail trading activity, said that the ratio of tobacco bond buyers to sellers was higher in August than it was in July. Despite Lipper FMI data — which shows four consecutive weeks of outflows for high-yield municipal bonds funds — BondDesk calculated that the average buy-sell ratio was 1.2 compared to 1.0 in July.

However, trading activity has been significantly lower in August than July. Average volume was 599 trades per week in July not counting the July 4 holiday week, compared to just 486 trades per week in August.

BondDesk also calculated that median yields of tobacco bonds have fallen sharply over the past few weeks. After peaking at 7% in mid-July, they were 5.54% the week of Aug. 15.

"At a time when yields are extremely low and Treasury rates are low, the opportunity in yield and future total return in the tobacco sector is compelling," Loughran said. "There are rating, volatility, and price risk, but you are more than fairly compensated, given the yield. So this is absolutely a buying opportunity, but you have to understand what you're buying."

Loughran said he is very bullish on the tobacco sector for several reasons, including the annual cash flow that comes to states from the MSA.

The agreement "has withstood many legal challenges over the years and it has won all of those legal challenges," he said. "So the MSA is here to stay."

Some of the states that receive annual cash flow from the agreement have securitized it, Loughran said, which means bondholders have a claim on the cash flow into perpetuity until their principal is repaid. So if a tobacco bond matures in some future year and the bondholder does not get paid in full, the claim on the MSA cash flow allows the bondholder to be first in line to get paid in the following year.

"It's a very powerful structure protection for bondholders, and so they have claims forever," he said.

Loughran added that the yields alone set tobacco bonds apart from the crowd. A New Jersey tobacco bond, maturing in 2041, yields 8% right now, and the tax-equivalent yield is north of 13%. "So that 13% taxable equivalent yield compares extremely well to almost everything out there in the world of fixed-income markets," he said.

There is also inflation adjustment in the MSA cash flow. "Usually inflation is a bad thing for bondholders but here it's a strength in tobacco bonds," Loughran said, adding that every year, the MSA increases cash flow by 3% or the consumer price index, whichever is higher. For the first seven months of the year, the CPI is up 2.4%, so based on that, it could be 4% annually. The cash flow from the MSA with inflation adjustment would then be 4% instead of 3% for the tobacco bonds.

One of the main risks to tobacco bonds is the decline in cigarette consumption. In 2009, Americans smoked 325 billion cigarettes, marking a 9.3% decline from 2008 and a 4.3% decline annually over the previous five years. However, Loughran said that the federal government increased the excise tax on cigarettes two years ago, causing consumption to decline, but that so far this year, that decrease is moderating.

"Some market participants just look at the last year or two of data and straight-line that into the future. But that's a mistake," Loughran said.

Citi analyst George Friedlander wrote in an Aug. 19 note that now is a good time to buy short-maturity tobacco bonds. "The yield pick up looks extremely attractive, compared to depressed U.S. Treasury levels," he said.

Not everyone agrees that now is the time to jump into tobacco bonds. Chris Ryon, portfolio manager at Thornburg Investment Management, said tobacco yields are on the rise again as a "memo of understanding" dispute earlier this year regarding payments from participating cigarette manufacturers to states appears to be falling apart.

When it was initially struck, the agreement — in which participating manufacturers decided to split the disputed payment with the states in return for better market-share protection — looked like it would pass and yields fell. Ryon said since then, yields have risen as several large states have chosen not to sign the agreement.

"Yields on most tobacco securities have reversed course and are increasing in the face of historic low yields on Treasuries and declining yields on high-grade municipals," he said.

Ryon is not buying tobacco bonds now, even though he has owned them in the past. "I think they are a risky asset to own and you have to be ready to endure a lot of volatility," he said.

Richard Larkin, director of credit analysis at Herbert J. Sims, said the Golden State corporation, the Buckeye authority, and the Virginia Tobacco Settlement Financing Corp. will all be forced to dip into reserves in order to make interest payments by the end of this year.

But "while the need to use reserve funds to meet minimum debt service requirements is troublesome, it does not mean that any tobacco bonds, including those of Golden State, Virginia, and Ohio's Buckeye, are in danger of imminent default," he added.

Larkin said that a lot of the default risk comes in the long end of the curve — after 2025 or 2030 — when tobacco issuers may have to go to the reserve funds to meet minimum payments.

While Larkin is not buying tobacco bonds now, he says at some point prices could create a buying opportunity.

As an example, he said if an investor could buy a tobacco bond for 50 cents on the dollar, and make 10% a year for 30 years, the extra yield could totally offset the risk that principal might not be paid. If 2041 comes around and the investor doesn't get the principal back, they have still made enough in interest to compensate for the principal loss.

"Crudely speaking, it's like buying a 5% municipal bond and getting your original investment back over 30 years," Larkin said. "So at some point, these prices are attractive. But we're not there yet."

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