CHICAGO — The majority of tobacco settlement bonds rated by Moody’s Investors Service will default if smokers keep up their current pace of kicking their habits or cutting back on them, the agency warns in a new report.
Nearly 75% of the bonds rated by the agency that are backed by payments under the 1998 Master Settlement Agreement between most states and participating tobacco manufacturers are headed towards default if consumption dwindles annually at a 3% to 4% rate. Moody’s rates a total of 32 tobacco settlement securitizations with a balance of $20.4 billion outstanding.
Cigarette shipments declined by 5.6% in 2011 and 6.45% in 2010, following a 9.2% decline in 2009, according to Herbert J. Sims & Co.
Shipment rates, which track closely with consumption, are a factor in the formula used to set the annual MSA payment. The National Association of Attorneys General this spring projected that states will receive $6.1 billion this year under the settlement, up from $6 billion a year ago.
“Characteristics that lead bonds to be vulnerable to a lower rate of decline include high leverage, long bond maturity and low cash reserves,” said Irina Faynzilberg, a senior credit officer.
Faynzilberg co-authored the report “Sustained Decline in Cigarette Consumption Rates Will Cause Many Tobacco Settlement Bonds to Default” with analyst David Nathanson. It was published Thursday. Nearly 80% of the tobacco settlement bonds rated by Moody’s carry below-investment-grade ratings of B1 or below.
The report reviews the break-even decline rates for individual tranches to assess at what level they face eventual default. The agency found that 15 tranches accounting for 44% of rated bonds break even at 2% to 3%, and another 41% making up the remaining balance of tobacco settlement bonds have a break-even point of 3% to 4%. The analysis assumes a constant rate of decline for the duration of the bonds’ life, Moody’s noted. The assessment is based on a cash-flow analysis.
Tranches of bonds within a securitization that carry investment-grade ratings in the A category all typically can withstand double-digit annual declines.
Moody’s last year revised its tobacco bond rating criteria, incorporating more rating-by-maturity criteria and increasing its base-case shipment decline assumption from a negative 3% annually to a negative 4% annually.
High leverage, long bond maturity and low cash reserves are the driving factors behind the tranches, with less tolerance for falling consumption.
The use of reserves by some tobacco issuers have signaled the troubles that lie ahead for the sector. California’s Golden State Tobacco Securitization Corp. withdrew $9.5 million from debt service reserves to help make an interest payment of more than $155 million on Dec. 1, 2011. The draws were the second in as many years. The previous December, the corporation drew $12 million out of its reserves.
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, Ohio and Virginia have some of the thinnest debt service coverage levels among tobacco-bond issuers.
Dick Larkin, director of credit analysis at Herbert J. Sims who has long followed the sector and warned early of looming troubles, said he doesn’t see decline rates tapering off.
The $50 billion sector is stressed on several fronts. One is the ongoing dispute between states and the participating manufacturers over non-participating manufacturers. Under the 1998 settlement, tobacco companies can seek a reduction in their MSA payments if they can show they lost market share to non-participating manufacturers due to the pact. The issue is the subject of arbitration and $7 billion is currently being held in a disputed account.
Local government and state cigarette tax increases are also key drivers behind consumption declines and Larkin said government moves to ban smoking in more public places were also an influencing factor.
More recent tobacco bond issues have built in much more conservative estimates for cash-flow coverage of annual debt-service costs. Both Illinois’ 2010 issue and Minnesota’s 2011 tobacco issues can withstand steep annual declines.
Bondholders would continue to receive full payments even at a 10.07 % annual drop, but the debt service reserve would need to be tapped on the Minnesota deal. The Illinois deal offered similar protections but its bonds could withstand the 10% decline with reserves intact.
The offering statement on Minnesota’s deal late last year included an October report from IHS Global Insight Inc. that forecast consumption will fall by 46% to 163 billion cigarettes in 2030 from 2010 levels of 301 billion.
Declines in cigarette use accelerated in 2002 and 2003 to 3% due to rising state excise taxes. It then moderated for the next four years at a 2% rate. Consumption then began escalating with a 4.2% in 2008, an 8.3% in 2009 and a 5.3% in 2010, according to the report.