With the retail order period for California’s $4.5 billion tobacco bond sale already underway, sources from around the muni market said they expect to see some extra yield tacked on when the debt is priced for institutional investors tomorrow.
The market’s response to the Golden State Tobacco Securitization Corp. will be closely watched, following the fallout from the $3.6 billion tobacco deal marketed Jan. 23 by the New Jersey Tobacco Settlement Corp.
Bear, Stearns & Co. — which ran the books on the New Jersey deal — is pricing the Golden State deal. Officials at the firm declined to comment on the California transaction.
The Golden State deal could be a barometer for the ongoing viability of tobacco bond sales, traders and analysts said. While the New Jersey pricing could have been simply a product of one day’s market conditions, a rough sale for Golden State bonds could show waning market interest.
“One has gone bad, and if two go bad it could mean a change for how tobacco bonds are viewed in the market,” said B. Clark Stamper, portfolio manager at Stamper Capital & Investments Inc.
Tomorrow’s deal will also hinge partly on an unexpected sell-off in international equity markets last week, leading to the single largest drop in the Dow Jones industrial average in three years.
Muni bond prices rallied last week, as skittish investors put their money into bonds to weather the storm. Global economies will continue to be the focus this week, according to Stamper.
However, Stamper said problems for equities could also mean problems for the Golden State bonds, which are rated in the triple-B range like most tobacco settlement debt.
“We’ve seen this meltdown in the equity market, so that may also mean that the desire of the market for lower-quality investments, including low-quality municipal bonds, will diminish as investors are stirred up over the last week or so,” Stamper said. “And that will mean that they will have to price it cheaper, rather than richer, based on the overall financial market experience.”
Others said that the equities scare would drive more market participants into bonds, including tobacco bonds because they are generally safer investments.
“The most important issue at this point is what is going on in the stock market,” said Jim Dolan, chief executive officer of Alta Capital Group LLC. “The municipal market is trading off what happens in the equity markets right now, so if you get a second wave down in the equity market then you will see a run-up in the fixed-income side and it will help the credit. There is a lot of retail demand for this and widespread institutional support so they won’t have any problems getting the deal done.”
Another major factor for the deal will be the fourth-quarter unit labor costs, scheduled for release this morning. The Federal Reserve Board has pointed to this indicator as an increasingly important one as the Fed continues to be concerned with inflation in the economy.
“If labor costs come in above expectations, it will really spell bad news for the municipal bond market,” a trader in Los Angeles said. “We haven’t handled poor inflation news very well in the past year, and if this one comes in bad right before Golden State prices for institutional accounts, it won’t be pretty.”
Economists polled by IFR Markets predict unit labor costs to come in at 3.4%, well above the third quarter’s figure of 1.7%.
So who is going to buy the $4.5 billion of tobacco bonds set to price this week?“There’s probably a hundred [tobacco] deals that have happened, and everybody asks that same question before each deal,” said Si Matthies, executive vice president of institutional brokerage and sales at Wells Fargo. “Somehow, they get soaked up.”
During the past few years, an increasing number of alternative investors have shown up on the investor side of the municipal market, helping to drive demand up and yields down on longer maturities — sometimes even in the face of economic reports that would otherwise weaken prices.
These new investors, such as hedge funds, arbitrage accounts, and overseas investors, have shown an appetite for longer, more complicated deals. But sources said that these types of investors might not buy these Golden State bonds as quickly as they have swallowed up other similarly sized deals.
“The reason they wouldn’t be interested in these bonds may be that it is a little bit more difficult to understand what exactly is going on,” Stamper said. “When they had traded way down it was a slam-dunk buy, but at these levels they aren’t a slam-dunk buy.”
The recent shift of alternative buyers from cash investments into swaps could leave fewer of them interested in the Golden State deal, according to Matt Fabian, senior municipal analyst at Municipal Market Advisors.
Demand for California’s tobacco bonds will likely have to come from traditional sources, he said.
“It will probably fall to the funds and maybe some other traditional buyers,” he said. “In the past they have not been amenable to perpetuating these very rich levels we’re at. They’ve been the ones who are generally unhappy with the level of yields, and if you have to rely on traditional investors, you may wind up having to price your bonds more cheaply.”
International investors, which are typically interested in U.S. municipal credits for their strong credit profiles and relative isolation from other types of investments, are not interested in buying tobacco bonds because they are too closely correlated with the health of the tobacco industry, several sources said.
Tobacco bonds are leveraged off dollars from the 1998 Master Settlement Agreement between cigarette makers and 46 states. The agreement allows tobacco companies to reduce their payments if they experience annual market share losses greater than 2% to other cigarette companies that did not sign the MSA.
“Any buyer of a Cal bond should expect that there’s going to be a large-scale dispute this year, and that expected prepayments may get even thinner than they were last year,” Fabian said. Annual payments are usually made on or about April 15 of each year.
