Fitch Drops $9B of Ohio and California Tobacco Debt

CHICAGO — With tobacco consumption continuing to decline, Fitch Ratings last week downgraded $9 billion of tobacco bonds issued by Ohio and California after the two states were forced to draw on reserves to make their Dec. 1 payments.

Fitch dropped five series of Golden State bonds to BB-minus from BB. The nine series of downgraded Buckeye tobacco bonds now have ratings that are B, B-plus or BB, depending largely on the maturity. All have negative outlooks.

The downgraded debt is either capital appreciation bonds or turbo-term bonds, which are typically more leveraged and exposed to declines in annual payments. Fitch affirmed its BBB-plus on the two states’ serial bonds, which total $320 million. It has a BBB-plus cap on all tobacco bonds based on its view of the sector.

Ohio sold $5.5 billion of tobacco debt in 2007 through the Buckeye Tobacco Settlement Finance Authority. California in 2007 sold $4.5 billion through its Golden State Tobacco Securitization Corp.

Both states have among the thinnest debt-service coverage levels among tobacco issuers. Ohio in June warned investors that it would likely need to dip into its reserve account to make its December payment, and Fitch put the bonds on watch for downgrade shortly after the disclosure.

In late November, Ohio drew $7.3 million from its reserve account to make the payment, leaving the reserve account $7.3 million below its $389 million required minimum level, according to Fitch.

Fitch, like Standard & Poor’s, Moody’s Investors Service and other market participants, has warned for nearly two years that the $55 billion tobacco sector is suffering as smoking declines. That translates into lower-than-projected annual payments from the cigarette companies that participated in the 1998 Master Settlement Agreement with most states. The MSA payments back tobacco bonds.

Another problem is an ongoing dispute between states and tobacco companies that has prompted the companies to set aside portions of their annual payments into “disputed payments accounts,” .

The problems have meant issuers like Ohio and California will no longer be able to retire some of the bonds early with turbo redemptions as planned. All turbo payments are now expected to stop until reserves are back up to minimum levels.

For the serial bonds, issuers are expected to be able to continue to make the payments, Fitch said. A 2011 report noted that many tobacco serial bonds theoretically exceed Fitch’s BBB-plus cap.

The Buckeye serial bonds, for example, are “all above the cap, so they’re not in danger of being downgraded now,” said Fitch analyst Lauren Tierney.

If the payment dispute is settled, it would likely mean an infusion of cash for issuers that would help buoy troubled borrowers like Ohio and California.

“If it gets resolved, I imagine that it would generate a large cash flow into the transactions that are outstanding,” said Fitch analyst Cynthia Ullrich.

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