CHICAGO — Fitch Ratings Friday downgraded a swath of tobacco bonds — stripping some of their investment-grade ratings — as part of its annual sector review amid continued consumption declines by smokers and a dispute between the tobacco companies and states that is diminishing annual payments.
Fitch downgraded 98 of its roughly 250 ratings of bonds backed by tobacco payments. All of the downgraded debt is either capital appreciation bonds or turbo-term bonds, which are typically more leveraged and exposed to declines in annual payments, Fitch said. The rating agency did not downgrade any serial bonds in the sector.
Many investors have already been forced to shed their holdings after Standard & Poor’s last November dropped its ratings on almost half of the entire tobacco bond sector into junk territory.
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.
Municipal market participants and rating analysts have warned for months that the $54 billion sector suffers from chronic consumption declines that will force some issuers with thin coverage to dip into reserves as soon as this year.
The market also is troubled by an ongoing dispute between states and participating tobacco companies, which are setting asides portions of their annual payments into a so-called disputed-payments account.
This year’s payment, made in April, was 5% lower than the 2010 payment, due to both falling consumption and a decision by Altria Co., parent of Philip Morris and the largest participating cigarette manufacturer, to put a portion of its annual payment into the disputed escrow account for the first time. The disputed payments now total $7.1 billion.
A tentative agreement floated last month would have reportedly allowed tobacco companies to recoup $2 billion and re-write some of the rules of the 1998 agreement. But attorneys general from several states, including Utah and Missouri, have said they won’t sign off on the deal, a decision that will likely kill it.
Fitch analysts said they are monitoring the progress of a possible settlement but added that they restrict their analysis strictly to cash flow, and that any money released from the disputed accounts to the state would be considered a cash windfall.
Richard Larkin, senior vice president and director of credit analysis at Herbert J. Sims & Co., said he has held off on updating his most recent 2011 projections until the fate of the settlement becomes clear. An agreement would end a dispute many expected to last for years, but also would likely not mean enough money for the states to offset falling consumption, according to Larkin.
“It removes the headache that this dispute carries on for the next 10 years, but from a cash-flow point of view, the damage has been done. My gut tells me that what the states will get ain’t enough to offset the consumption decline,” he said. “If there is no settlement of disputed amounts, then the 2011 payments will definitely worsen my projections from last year.”
Larkin warned in a June report that 2011 shortfalls, combined with a 16.4% decline in 2010 payments, will force three major issuers, California, Ohio, and Virginia, to tap reserve funds to make 2011 debt-service payments.
As part of its review, Fitch downgraded to BB-minus from BBB-minus and assigned a negative outlook to four series of turbo-term bonds issued by California’s Golden State Tobacco Securitization Corp. that mature in 2027, 2033, and 2047.
Fitch also put the turbo bonds and CABs issued by Ohio’s Buckeye Tobacco Settlement Financing Authority on rating watch negative and downgraded several tranches, saying that it will downgrade the bonds if a future draw on reserves pushes it below a minimum threshold outlined in bond documents.
Fitch caps tobacco bonds at BBB-plus, based on its view of the sector.
Moody’s Investors Service in May updated its assumptions to reflect consumption declines as well as other changes, including the escrow dispute.
As part of the revision, Moody’s put 14 tranches in five securitizations, totaling $739 million, under review for possible downgrade. But the rating agency also put 19 tranches in nine securitizations, totaling $883 million, on review for possible upgrade, saying that those bonds feature significant cash reserves and relatively short-term maturities that minimize the impact of projected future cigarette declines.