This week didn’t exactly seem like an ideal time to float a tobacco bond.

No one had sold one in more than two years, and things were looking bleak. Standard & Poor’s had just knocked the ratings on almost half the $54 billion tobacco bond sector into junk territory — a massive downgrade that catalyzed widespread selling.

A few months earlier, the ­National Association of Attorneys General reported a severe decline in tobacco consumption, threatening the collateral supporting these deals and ­prompting one of the most prominent analysts following the space to predict ­defaults.

Yet by offering a very conservative structure, Illinois this week managed to find buyers for a $1.5 billion tobacco securitization in a stressed environment.

A coalition of underwriters led by Citigroup and Barclays Capital earlier this week priced the state’s Railsplitter Tobacco Settlement Authority’s tax-exempt bonds to yield 6.2% for the longest maturity, which is 17 years.

“I was a little surprised at the response from the markets, that there was that much appetite,” said George Strickland, a portfolio manager at Thornburg Investment Management. “I thought the traditional tobacco bond buyers were up to their eyeballs in tobacco bonds already.”

Thornburg bought a piece of the issue because it was ­structured more conservatively than most existing tobacco ­securitizations.

“This deal through our eyes looks different from the other tobacco bond deals. They sort of built in what we would view as a worst-case scenario for declines in cigarette consumption,” Strickland said.

This deal is more conservative than most other tobacco securitizations in two ways. One, it has far higher coverage levels, which is another way of saying it can tolerate a much more severe decline in smoking before it ­defaults. Two, it has a shorter maturity structure.

“They threw almost ­everything at it that they could in order to make it attractive to buyers,” said Tom Spalding, senior investment officer of Nuveen ­Investments. “They had to put a structure together that’s ­going to be salable, and that’s why they threw all these bells and ­whistles in.”

Spalding declined to say whether Nuveen’s $5.6 billion high-yield tax-free fund purchased any of the bonds.

Even with the conservative structure, the 6.2% yield for an A-rated bond ­maturing in 2017 is almost 150 basis points over the single-A scale for that maturity, according to Municipal Market Data.

Still, the fact that Illinois’ bankers were able to move this deal proves there is in fact pent-up demand for tobacco debt, even in the direct aftermath of a tobacco bond sell-off, provided it is designed with realistic assumptions for American smoking habits in the 21st century.

“This transaction was by far one of the more conservatively structured,” said Kym Arnone, a managing director at Barclays Capital who has worked on $37.2 billion of tobacco deals in her career, mostly at Bear Stearns. “Given the fact that this was viewed by investors as 'new tobacco,’ from a structural standpoint, meaning a ­significantly lower degree of leverage, investors were willing to participate, ­particularly investors who already owned tobacco.”

Until now, investors have ostensibly demonstrated little appetite for this kind of paper lately. Yields on existing tobacco bonds in the secondary market remain elevated, and the sector has not enjoyed good news in a long while.

The Railsplitter deal came on the heels of a distressed couple of weeks for tobacco bonds in particular and municipal bonds in general.

Benchmark high-grade yields spiked nearly 30 basis points in November, according to MMD, and credit spreads widened abruptly.

Plain-vanilla issuers like the Leander Independent School District in Texas, the Gwinnett County Water and Sewerage Authority in Georgia, and the Orange County, Sanitation District in California pulled deals off the market last month because of insufficient demand.

It was worse for riskier products. The Standard & Poor’s downgrade of tobacco bonds put them at the forefront of the sell-off.

Tim McGregor, director of municipal fixed-income portfolio management at Northern Trust, in a report last month noted “severe price/liquidity pressure” for certain tobacco bonds.

Retail investors responded by ­withdrawing nearly $2 billion from high-yield municipal bond mutual funds — major holders of tobacco debt — in the final two weeks of November, according to ­Lipper FMI.

Against this backdrop Illinois not only came to market with a $1.5 billion tobacco bond, but enjoyed a keen reception. The state raised cash to pay off a backlog of fiscal 2010 bills in its first foray into the securitized tobacco market.

“It was definitely well-received,” a trader in New York said. “Those were some attractive yields, with a 6-handle in the longest maturities, which weren’t even that long. It was certainly very attractive for yield-seekers.”

Illinois debt manager John Sinsheimer credited the state’s investment banks, as well as its financial adviser, Public Financial Management.

Because the state needed the money, Sinsheimer said it was ready to tailor the deal conservatively to placate investors. A nationwide road show with stops in New York, San Francisco, Los Angeles, Chicago, Boston, and Philadelphia drew “positive comments” from investors, he said.

“We structured these bonds to make sure that they were attractive to investors,” he said. “While the market was clearly choppy, we were getting indications from investors that they were enthusiastic.”

So enthusiastic were they that the state accelerated pricing by a day, after a strong retail-order period Monday in which substantially more than the allotted $300 million was sold to retail investors, according to market sources.

A Tough Month for the Sector

November might have been the roughest month for tobacco bonds since the financial crisis.

Tax-free bonds in general returned negative 2.4% in November, according to a Standard & Poor’s index, as the market grappled with hefty supply and an evaporation of demand from buyers.

On Nov. 11, Standard & Poor’s downgraded $22 billion of tobacco bonds, mainly those with lower coverage levels that make them more susceptible to declines in smoking.

This mass downgrade triggered a cascade of selling. The yield on the 2047 maturity of Ohio’s $5.5 billion Buckeye Tobacco Settlement Financing Authority deal shot from around 7.7% before the downgrade to as high as 9.8% a week later, according to trades reported through the Municipal Securities Rulemaking Board.

The yield on the 2047 maturity for California’s $4.4 billion Golden State Tobacco Securitization spiked 100 basis points the week after the downgrade.

The selling walloped the $50 billion high-yield tax-free mutual fund industry. Nuveen’s high-yield municipal fund lost 5.6% of its value in a week. Hartford Funds’ high-yield tax-free fund lost 4.1%.

Investors pulled $1.2 billion from high-yield muni funds during the week ended Nov. 17, according to Lipper, and funds reported a market loss of $2.1 billion on their holdings. The following week, investors pulled an additional $549 million.

Between outflows and market losses, the funds coughed up 6.4% of their assets during those two weeks. All of this while Illinois was preparing to sell its tobacco bonds. To wade into a market like this, the state would have to be different.

The genesis of the $54 billion tobacco bond sector came in 1998 when attorneys general in 46 states offered cigarette manufacturers immunity from state lawsuits in exchange for billions of dollars a year, every year, in perpetuity.

States quickly realized they did not have to wait for the payments under the Master Settlement Agreement; they could sell the rights to the future MSA payments to bond investors.

While the securitizations are straightforward, the potential variability of the settlement payments makes these bonds a decidedly high-yield product.

The wrinkle for investors is that the settlement payments to states are not fixed. Cigarette companies must pay an aggregate “base” of around $8 billion to $9 billion in settlement payments a year, but those can vary, hinging on a variety of factors.

The MSA document is 285 pages long, runs more than 67,000 words, appends 21 exhibits, and features “offsets for miscalculated or disputed payments,” “nonparticipating manufacturer adjustments,” “nonsettling states reductions,” and “federal tobacco legislation offsets.”

Considering how many complicated things influence the payments cigarette companies make to states — and that states use for payments to bondholders — the bonds have to be underwritten based on an imperfect guess about how much settlement money the states will collect over time.

The deals are structured with an assumed coverage level of settlement payments over interest and principal payments on the tobacco debt.

Because most tobacco bonds are backed only by the settlement payments and have no recourse to other revenues, the risk is that actual settlement payments will be lower than assumed payments, and coverage measures how much lower it can be before the bonds default.

While some tobacco bonds were underwritten with less coverage than others, the settlement payments have dwindled more than just about anyone thought.

MSA payments decline if overall tobacco consumption declines. Facing a barrage of excise taxes, smokers have cut back more than expected.

Americans smoked 325 billion cigarettes last year, according to the NAAG. This marked a 9.3% plunge from 2008 and a decline of 4.3% annually over the past five years.

The sharp downdraft in cigarette use was reflected in the payments that tobacco companies made to states this year: $6.39 billion. That is down 16.4% from last year and almost $2 billion below the “base” ­scenario of $8.14 billion contemplated when the settlement was first reached.

Few tobacco securitizations were ­structured to withstand declines like this over a prolonged period of time.

The Illinois Difference

What makes the Illinois structure unique is that it allows for the cigarette companies to pay a lot less than expected before it has trouble paying off its bonds.

The official statement for the Illinois tobacco bonds lays out a spectrum of hypothetical scenarios.

The first is that cigarette consumption declines 3% annually from now on. In that case, the MSA settlement payments would be sufficient to repay holders of the final maturity three times over.

The OS next speculates about a 4% decline, which is roughly equal to the annual decline the past half-decade. Should that persist, the structure would collect $275.8 million in settlement payments in 2027 and devote $106.8 million that year to pay off the last of its bonds — coverage of more than two and a half times.

The structure also survives a 5% decline, and a 7% drop. In fact, not until the annual rate of decline exceeds 10.04% for 17 years does this structure run out of cash before repaying principal on the final maturity.

Herbert J. Sims analyst Dick ­Larkin wrote in a report on Wednesday that many tobacco bonds were underwritten to tolerate a 4% annual decline. The Illinois deal offers two and a half times more protection than that.

Larkin contrasted the cushion in the Railsplitters structure to the Ohio Buckeye deal. Assuming a 4% annual decline indefinitely, the Illinois bond’s interest coverage would never drop below 1.72 times. The Ohio structure, on the other hand, would have to start tapping its reserves in 2019 and could default by 2030.

“Unlike virtually all other tobacco bonds, this new issue was structured with much higher cash-flow coverage of its annual debt-service costs,” Larkin wrote.

The other buffer protecting bondholders is the shorter maturity, with the final payment in 2027.

The Ohio Buckeye deal by comparison was underwritten in 2007 and does not reach its final scheduled maturity until 2052.

Joseph Darcy, who manages the $456.1 million high-yield muni fund for Hartford Funds, said a longer-term structure is inherently riskier because there is a greater chance of the forecasts being wrong.

“It’s the uncertainty surrounding the window of time in which the security exists, and the ability to forecast on that horizon,” Darcy said. “When you make assumptions over a relatively near-term horizon, you have a higher probability of being accurate than over the longer term.”

Another risk for the traditional tobacco structure is that it assumes the issuer will call some of the debt steadily over time, a process known as “turbo redemptions.”

That is yet another variable the ­investor needs to forecast, and another thing that can go wrong. If cash flows are ­insufficient to fund turbo redemptions, investors will hold the bonds longer than they ­expected. The Illinois bond is mostly non-callable, eliminating the need to forecast ­redemptions.

Darcy expects to see a few more tobacco securitizations, with a clear preference for conservatism. “The ones that are going to be accepted are the ones that are ­reasonable and conservative in their ­assumptions,” he said.

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