The investment case for tobacco bonds is that smokers are so hopelessly addicted they will continue buying cigarettes no matter what.

Dick Larkin knows first-hand this is not so. The director of credit analysis at Herbert J. Sims & Co. in the last few years has cut down from three packs of Marlboros a day to less than one, and not only for health reasons.

"It's getting more expensive and it's getting harder to find places to smoke," said Larkin, 57, who grew up in Queens, N.Y., and now works in New Jersey. "Tobacco consumption declines are going to be a lot greater than people think."

The dwindling rate of cigarette consumption in the U.S. - 3.7% annually, according to the Tobacco Tax Bureau - may be hailed by public health advocates, but it is bad news for tobacco bondholders.

Shrinking cigarette sales threaten to crimp tobacco companies' payments to states, which in turn would threaten cash flow to tobacco bondholders.

In 1998, 46 states and the four biggest tobacco companies inked the Master Settlement Agreement, the biggest civil settlement in U.S. history. In return for immunity from liability from states, tobacco manufacturers agreed to pay the states billions of dollars a year in perpetuity.

Many states have securitized these settlement payments, or sold to bondholders the right to receive future cash flow from the MSA. Investors own about $36 billion in tobacco bonds.

Payments under the MSA - and consequently the value of tobacco bonds - can go down if cigarette sales volume declines. That is what worries Larkin. He believes cigarette sales are declining 4% annually because of mushrooming costs to buy a pack of cigarettes and a blizzard of state and local laws prohibiting smoking in public. His projection this year is dire.

A 62-cent federal excise tax-hike to support the State Children's Health Insurance Program will raise the average cost of a pack of cigarettes by 15%, Larkin estimates. Just yesterday, Philip Morris USA announced it will bump prices by 71 cents a pack for most brands.

Further, Larkin anticipates states will raise taxes on cigarettes as they try toclose budget gaps.

Citing studies showing every 1% escalation in price squeezes consumption by 0.3% to 0.5%, Larkin crunched the numbers and predicted a 9.6% decline in consumption this year.

"You're going to see a dramatic decline in total payments under the settlement next year," he said.

Larkin foresees the cuts in MSA payments leading to fewer turbo redemptions, which occur when states use excess cash from the settlement payments to redeem outstanding bonds prior to maturity.

Turbo redemptions of Washington State's tobacco bonds, for example, would decelerate 53.3% should Larkin's prediction come true, he estimates. California's unenhanced tobacco bonds' turbo redemptions would plummet 84.5%, he estimates.

Larkin is a credit analyst, not a value investor. He is not passing judgment on whether tobacco bonds - many of which trade at less than 60 cents on the dollar - are a good buy at these prices.

He does dispute the prevailing belief that the credit crisis is what primarily has hammered tobacco bonds.

"I don't buy it," he said, claiming prices in this sector have plunged more steeply than other types of bonds plagued solely by illiquidity. "I think that's the realization that consumption declines are finally starting to kick in here and it's not looking good."

Other than consumers' shrinking appetite for cigarettes, tobacco bonds face a raft of other challenges.

While the MSA protects participating manufacturers from lawsuits filed by states, the companies still face an onslaught of litigation from smokers.

The tobacco companies so far have fought their legal battles adroitly, but adverse surprises in the courts could result in constrained finances for the manufacturers.

Further, the companies are contesting more than $4 billion in MSA payments. Companies can challenge their share of the MSA if they can show they lost market share because of the settlement and prove the states failed to collect money from tobacco manufacturers that do not participate in the MSA, which the states are required by statute to do.

Given tobacco companies' success in legal entanglements thus far, Larkin believes the tobacco companies have a good shot at recouping some of the disputed money. Money that goes back to the companies is money that does not go to the states and bondholders.

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