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South Dakota Restructuring $171M of Tobacco Bonds Amid Uncertainty

CHICAGO -- South Dakota is hitting the market Thursday with $171 million of tobacco bonds that will refund the state’s original 2002 sale and restructure the debt from the original full-turbo payment structure into a fixed amortization schedule.

The state expects to save roughly $3.5 million by refunding in a lower interest-rate environment, officials said.

The bonds are secured by 100% of South Dakota’s share of the revenues it receives under a Master Settlement Agreement with tobacco companies in 1998.

The deal comes two months after the participating tobacco manufacturers settled with 17 states -- not including South Dakota -- and two territories to resolve disputes over payments from 2003 through 2012.

South Dakota was not part of that litigation though the settlement could impact future payment adjustments to all states, analysts said.

While many states, like Minnesota and Wisconsin, have used proceeds from tobacco securitizations to fill budget shortfalls, South Dakota set up an educational trust fund with the original 2002 bond issuance, and uses the dollars to finance educational enhancements across the state.

“The South Dakota tobacco financing is unusual because under the state’s constitution, all of the bond proceeds as well as all of the tobacco settlement receipts that don’t go to pay off bonds go into a trust fund for enhancement of public education,” said Jack Arnold, senior vice president at Dougherty & Company LLC, the co-senior manager on the deal. “So we aren’t in a position to use receipts either to fill budget gaps or to pay for infrastructure.”

Since 2002, however, all of the state’s tobacco receipts have been used to make turbo payments to the bonds. Refunding into a fixed amortization schedule means there will be excess proceeds to go into the education trust fund, Arnold said.

“It just gets more money into the trust fund,” he said. “Once there’s more money in the trust fund then there’s more earnings available for education in South Dakota.”

The $171 million deal is divided into two series. A $122.5 million taxable series matures from 2013 through 2023, with debt service declining every year through maturity.

A $48.2 million tax-exempt series will begin payments in 2023 and continue through 2028, down from the original maturity of 2032.

Barclays is the senior manager. The Educational Enhancement Funding Corporation is the issuer.

Standard & Poor’s assigned an A rating to the bonds that mature through 2023 -- nearly all of which are taxable -- and an A-minus to the tax-free bonds that mature from 2024 through 2028. The one-notch difference in ratings reflects the risk of accurate projections and uncertainty in the tobacco industry over the longer time frame, Standard & Poor’s said.

Another key credit consideration is the deal’s structure, which can withstand a nearly 10% annual consumption decline as well as a fully funded liquidity reserve account to cover payments for one year, analysts said.

The lack of any full-turbo repayment bonds is considered a weakness by S&P, which said turbo bonds “could more effectively mitigate the risks related to cigarette consumption forecasts and potential market share shifts to the non-participating tobacco manufacturers from the participating manufacturers.”

S&P is the only agency to rate the debt.

In December, the MSA’s major participating tobacco manufacturers and 17 states and two territories announced a settlement that resolve a dispute over payments since 2003. The agreement includes a 2013 payment of more than $4 billion to the states, but the tobacco companies will reduce future payments.

An arbitration panel must still approve the deal.

The settlement would result in a one-time windfall for the participating states in 2013 and could stabilize future payments, according to Dick Larkin, director of credit analysis at Herbert J. Sims.

But the states would have to pay back nearly half of the payments in refunds to the companies over the next four years, Sims noted.

States like South Dakota, which were not part of the original dispute, could still be affected as the settlement could determine future payments to all states, analysts said. Other states are not part of the settlement but continue to challenge the 1998 MSA in hopes of a big payout.

“[The outcome of the term sheet is likely to affect this [South Dakota] transaction because we believe that it could set a precedent for the resolution of the subsequent disputes and may influence the way the participating manufacturers choose to make these adjustments in the future,” Standard & Poor’s wrote in its ratings report on the South Dakota deal.

The MSA challenges and ongoing cigarette consumption decline translate into uncertainty across the sector, Larkin said.

“South Dakota is going to have a cloud over its head just like all other tobacco bond issuers because of the dispute, and no one is sure who’s going to win and who’s going to lose,” said Larkin. “People who are buying tobacco bonds will have this big uncertainty.” He said states like Minnesota and Illinois, which crafted conservative deals that feature 10 or 15 times coverage eliminated a lot of the long-term risk.

“That’s why they were successful,” Larkin said. “But the uncertainty is why the yields on tobacco bonds is as high as 7% or 8% --  no one is sure if there is enough money to cover the maturities.” 

South Dakota’s bonds are built to withstand a 9.8% annual consumption decline, according to bond documents. The deal also features a fully funded liquidity reserve account that could cover interest and principal payments for nearly one year.

An analysis in preliminary bond documents outlines four different decline projections, including 5%, 7%, 9%, and 11% annual drops. A 9% decline would represent a ‘break even’ consumption decline rate at which debt service on the bonds would still be paid in full assuming the liquidity reserve account is maintained, according to bond documents. Coverage ratios would range from 1 times to 1.27 times and 2.11 times in the final 2028 year.

An 11% decline would mark a consumption decline rate at which all debt service would be paid in full assuming the liquidity reserve account is used to pay debt service prior to the final maturity of the bonds without a payment default. In the event of an 11% decline, coverage ratios would largely hover around 1 times, with small increases in early years and a 1.58 times rate in 2028.

A piece of South Dakota’s original 2002 tax-exempt tobacco bonds with a 2032 maturity and 6.5% coupon yielded 1.85% in trading last week, according to the Municipal Securities Rulemaking Board web site. Taxable bonds with a 2025 maturity and 6.72% coupon yielded 6.66% in most recent trading.

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