Ohio, Virginia Tap Reserves for Dec. 1 Tobacco Bond Payments

CHICAGO — As expected, Ohio and Virginia were both forced to dip into reserve funds to cover their Dec. 1 interest payments on more than $7.2 billion of tobacco bonds.

Like California, which also needed to tap reserves to cover its December payment, Ohio and Virginia have some of the thinnest debt-service coverage levels among tobacco-bond issuers.

Market participants and analysts have warned for months that the $55 billion tobacco-bond sector is suffering as smoking declines. That translates into lower-than-projected annual payments from the the major cigarette companies that participated in the 1998 Master Settlement Agreement with most states.

Another key problem is an ongoing dispute between states and tobacco companies, which are setting aside portions of their annual payments into so-called disputed payments accounts. The accounts are now estimated to total more than $7 billion.

Tobacco bonds are backed by payments made under a 1998 Master Settlement Agreement that requires tobacco manufacturers to make annual payments to states based on consumption and other factors. 

The companies’ annual payment in April 2011 was 5% less than a year earlier both because of fewer smokers and because Altria Group Inc., the parent of Philip Morris USA Inc. and the largest manufacturer in the settlement, decided for the first time to put part of its payment into the disputed-payment account.

Like Virginia, Ohio warned investors months ago that it would likely need to tap reserves to cover its December payment.

“Back in June, we let the market know that we felt [a reserve draw] was likely given the level of receipts in April and also the amount of money deposited in the disputed account,” said Ohio debt manager Kurt Kauffman. “Everyone saw the writing on the wall.”

The Buckeye Tobacco Settlement Financing Authority drew $7.4 million out of its reserve account to pay part of the $137.4 million interest payment due Dec. 1, according to a disclosure notice.

California’s Golden State Tobacco Securitization Corp. drew $12 million out of its reserves to cover its $155 million payment.

The Virginia Tobacco Settlement Financing Corp. drew $3.64 million from its reserve to supplement its interest payment on $1.5 billion of bonds issued in 2007. The reserve account had a remaining balance of $81.75 million.

The Buckeye bonds, issued in 2007 at the height of the credit bubble, were structured to withstand a 4% consumption decline.

More recent tobacco bond issues, in contrast, have built in much more conservative estimates for cash-flow coverage of annual debt-service costs. Illinois’ Railsplitter bonds, for example, allow room for steeper declines of as much as 10% before reserves would have to be tapped.

Kauffman said it was too early to tell whether Ohio would again need reserves to make its next payment, which covers both principal and interest, next June.

“It’s very difficult to predict what’s next in 2012,” he said. “I’m hearing that consumption decline has moderated, so that would help. The key thing for the next payment is what is deposited into the disputed accounts and whether there is any release from the accounts.”

Kauffman said the state has not run the numbers on how many payment declines it could withstand before reserves are depleted.

If Ohio drains its reserves, the bonds will remain outstanding longer than expected, exposing investors to what is called extension risk.

The Buckeye bonds’ final maturity is 2052, though the state originally projected the bonds to be retired by 2034 as a result of turbo redemptions. With less money to pay debt service, the rate of turbo redemptions will slow or stop in future years.

Richard Lehmann, president of Income Securities Advisors, tracks troubled municipal debt. He predicted that nearly all issuers will be forced to use reserve funds next year to cover payments, an action he calls a default.

“Tobacco bonds alone are going to make 2012 a record year for defaults,” Lehmann said. “This is a slow-moving train wreck. All these bonds were premised on a projection of tobacco consumption over 20 to 30 years. You can’t predict that. So the day of reckoning has come.”

In addition to the smoking decline and the dispute between tobacco companies and states, many state governments are also seeing lower than expected earnings on their escrow funds, Lehmann noted. “They all have to be building up sinking funds, and that was all built into the projections, including an assumption about rate of return,” he said.

Buckeye bonds maturing in 2030 yielded 9.3% in recent trading. Zero-coupon bonds maturing in 2052 saw yields of 12.3% in trading earlier this week, according to the Municipal Securities Rulemaking Board’s website.

On the Virginia bonds, a customer on Friday bought $40,000 of senior bonds maturing in 2046 for 62-cents on the dollar to yield 10.97%. Some of the subordinate bonds are trading for pennies on the dollar.

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