Zero coupon tobacco bonds may fall especially hard when interest rates begin to rise, according to analysts who follow the high yield, long maturity securities.
J.R. Rieger, global head of fixed income at S&P Dow Indices, lists the heavy issuance of zero coupon tobacco bonds as one of the two largest risks to the tobacco sector in an Aug. 8 report, along with a decline in tobacco use in the U.S. The long duration of zero coupon tobacco bonds means the prices will fall faster and farther than the already risky coupon bearing tobacco bonds in a rising rate environment.
Rieger estimates the par value of outstanding zero coupon tobacco bonds at $67.7 billion, or just over 74% of all tobacco bonds. Their estimated market value is $3.2 billion, or about 14.3% of all tobacco bonds, he said in an email. Interest rates are likely to rise because the Federal Reserve is tapering its monthly asset purchase program and its chair, Janel Yellen, has said Federal Reserve expects to raise interest rates in mid-2015.
"Yes, [zero coupon tobacco bonds] are riskier with the specter of interest rates rising," Dorian Jamison, municipal research analyst at Wells Fargo Advisors, said in an interview. "Since we have an idea [interest rates] are going to rise in the time frame Yellen has given us, it is probably not the best time to get into zero coupon, long duration, high yield tobacco bonds."
Tobacco bonds in general have been attracting investors lately because the sector has generated solid returns this year and the bonds offer investors high yields in a low yield environment. The Standard & Poor's Municipal Bond Tobacco Index has returned 9.91% year-to-date, while the broader S&P Municipal Bond Index has returned 8.57%.
Analysts, who have questioned whether this return is worth the risk, say their concerns are exacerbated in the case of zero coupon tobacco bonds.
Zero coupon bonds are bonds that compensate for the lack of interest payments by offering investors the opportunity to buy the bonds at a discount and then redeem them for the full price at maturity.
Jamison said that speculative investors are typically attracted to these bonds, and to zero coupon tobacco bonds especially, because discounts are steeper, boosting the potential return when the bonds mature.
"The investors who purchase these bonds are not unsophisticated, they are probably fully aware of all the risk including interest risk when they bought bonds," a spokesman for California's Treasury Department said in an interview. "We sell the bonds and go about the business of paying them off as required, that's our interest."
Richard Larkin, senior vice president and director of credit analysis at HJ Sims, said in an interview that some investors who purchase these bonds are doing so because they expect the type of windfall that happened to New Jersey tobacco bondholders in March. In that case the New Jersey State government decided to give 23.74% of future payments from tobacco companies to pay bondholders whose security revenues might never see repayment, Larkin wrote in a May article.
"It is estimated that these last-in-line bondholders may now be fully repaid as early as 2023," Larkin wrote in the report. He noted that the official statement for the one of the bond issuances that was paid back to investors, had warned that the subordinated bonds "may never be repaid."
The fact that many tobacco bonds with long maturities may never be repaid makes zero coupon bonds risky even in an environment where interest rates are stable, according to analysts. The main reason the bonds are still unsafe is because they carry the credit risk associated with all tobacco bonds.
"In a stable environment we are more concerned with credit risk to tobacco bonds and the risk of consumption declining which is reducing the payment for tobacco bonds," Jamison said.
Tobacco credits face a host of hurdles, including a decline in the amount of people smoking, the rise of e-cigarettes, and higher taxes on tobacco products, such as the one proposed in President Obama's 2015 budget draft.
On May 1st the National Association of Attorneys General released data showing that domestic cigarette shipment volumes fell 4.9% in 2013, one of the largest annual declines since 1999 when the group first began reporting figures, Moody's Investors Service wrote.
In July Moody's predicted 74% of bonds making up the aggregate outstanding balance of all tobacco bonds will default.
Such projections are especially worrisome for zero-coupon tobacco bonds, because their longer maturities make them more susceptible to default risk.
"Zero coupon bond holders are at the back of the line," Larkin said. "These people are going to be waiting a long, long time before see their money back. There are a lot of people in front."
He predicted that most zero coupon tobacco holders will never see repayment.
Jamison said that the concern for zero coupon tobacco holders is amplified in a rising rate scenario because the bonds' duration risk increases.
"The concern for zero coupon bonds is that they will have higher interest rate risk because they have higher duration, because their cash flows are received at the end," he said. "In a rising rate environment the zero coupon bonds with their high interest risk and longer durations have greater price sensitivity to risking interest rates than coupon bonds."
As base rates begin to rise, according to Rieger, the prices of the bonds will fall, and the prices of zero coupon bonds will fall at a faster pace and the price change will be greater for zero coupon bonds.
"In rising interest rate environment you want to own a coupon bond rather than a zero, because some return is coming back in near term allows you to reinvest at higher interest rates," he said.
Jamison said that duration risk couples with tobacco bonds' underlying credits risks puts these bonds on the "extreme" end of the risk spectrum.
"When interest rates begin to rise you will expect to see high yield sell off first, or more dramatically, than high quality bonds," and the risk of zero coupon bonds would be "exaggerated." he said. "The decrease in bond value would be worse for high yield zero coupon bonds."
