Now that the municipal market has digested two very similar tobacco settlement securitizations, the structure of such financings may become more varied as issuers with more financial flexibility or wider constituencies put together deals.
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Following the successful deployment by New York City and Nassau County, N.Y., of a two-tiered amortization structure -- a novelty in the municipal market that relied on asset-backed financing techniques -- the flavor of upcoming tobacco bond offerings may begin to change, according to sources.
As more municipalities choose to capture the present value of their expected settlement proceeds, the underpinnings of tobacco deals should evolve, particularly as state-level issuers and communities with no urgent fiscal needs consider ways to benefit.
For example, financially healthy Westchester County, N.Y., is likely to be the third municipality to sell this type of bond, with a sale scheduled for mid-December, pending the county legislature's approval. And it plans to eschew the dual-amortization tobacco bond model in favor of more familiar, capital appreciation bond structure.
While such a method would put a new twist on tobacco debt, all the deals would have one thing in common: the three issuers have appointed Salomon Smith Barney Inc. as the book-runner for their securitizations.
The interest in developing a different structure may be driven by the urge to tailor a product that is more appealing to retail investors. A benefit is that the average investor would be more attracted to a structure that is not as complex as New York's, Eric Altman, a managing director of public finance with J.P. Morgan Securities Inc., noted at a recent conference held by The Bond Buyer in Boston.
In the two-day retail order period for its $709 million deal, New York City's Tobacco Settlement Asset Securitization Corp. sold $50 million, or 7%, of the bonds. While retail investment advisers submitted additional orders during the institutional pricing, that level of participation pales in comparison with the city's general obligation deals, which usually give up more than 20% to individuals.
While complexity could be a reason for weak retail showing, investors may simply have no interest in this type of tobacco debt yet, said John Hallacy, managing director of municipal bond research with Merrill Lynch & Co. For instance, retail investors prefer par bonds and serials, especially in the one- to 10-year range, he noted.
But a zero-coupon structure could be appealing for a couple of reasons. While this type of security has been out of favor due to relatively low interest rates, a tobacco issue by nature should offer more yield than similarly rated bonds. Thus, the relative value and more common structure could broaden the market.
The zero-coupon structure may have appeal with issuers for other reasons as well.
Many municipalities may have already included tobacco settlement revenues in their preliminary budget plans for the next two or three fiscal years, but by structuring a securitization around capital appreciation bonds, they can back-load bond payments and follow their existing strategies, according to a source close to the early tobacco deals.
The zero-coupon structure, so long as it met stress tests, would likely receive the same A-plus rating from Fitch IBCA Inc. that the agency assigned New York and Nassau's deals, said Fitch managing director David Litvack.
A desire to draw retail demand for tobacco bonds or to work around already established uses for tobacco settlement revenues are not the only things that may change the shape of future issues, though.
Recently, Virginia selected Morgan Stanley Dean Witter to underwrite its planned tobacco bond sale, projected for next year. If Virginia follows through on its plans, it could be the first state to reach the market with tobacco-related debt.
Separating a state-level deal like Virginia's from those of Nassau and Westchester counties is the wider scope of the approvals needed to bring the issue to fruition, professionals noted.
Helen Cregger, a vice president with Moody's Investors Service, said that the prevalence of county and city issuers in the first rank of tobacco bond deals may have to do with the narrower base of support needed to obtain approval.
There may be several reasons why initial tobacco bond issuance has occurred on the local rather than state level, she said.
Needs on the county level are usually smaller in scale and, in the process of getting approval for a plan, officials cater to a more narrow constituency, Cregger said. Plans on the state level must take into account a broader and often more divided citizenry. Such an environment can pose more obstacles to getting a deal done.
However, New York State and California are likely to be the only states where counties will conduct their own securitizations.
But with states beginning to muster the will to develop tobacco bond plans, securitization at that level could take the shape of a standard program, Hallacy said. The communities that have already securitized their expected revenues or are very close to doing so are "mature" communities whose deals have been structured to meet well-defined needs, he said.
For example, Westchester's securitization would be used to fund the county's financial obligations to the county medical center, which run through 2007.
Possibilities for new development in the county "are pretty limited," Hallacy said. "The tax base is not going to grow the way tax bases in other locales are growing, so they have different needs. They have an aging population and they're spending more money on health care," so county leaders have determined their plan constitutes the best use for the tobacco money.
Future financings, particularly for municipalities that need to address the question of community growth, are likely to revolve around programs established to meet particular needs, Hallacy said.
"Governments are thinking about the programmatic aspects," he said. "Even though they may be very aware of these deals, that's not their first thought."
The question of financing will become step two, rather than step one, as it was in New York and Nassau where the needs were immediate, well-defined, and readily apparent, according to Hallacy.
Robert Muller, managing director of municipal research with J.P. Morgan, has estimated that the tax-exempt market has the capacity to absorb between $10 billion and $15 billion of tobacco issuance. The ultimate figure, he has said, may depend on the rating levels the deals can attain. The closer issuers can get to the double-A range, the wider the potential investor base.
Of course, many issuers, even those with large capital improvement needs, may forgo the chance to securitize their settlement payments. Jeff Stearns, deputy treasurer for debt planning in Massachusetts, said the state has decided to use 70% of the settlement payments to fund a trust that will generate income for cash budgeting.
Many firms have approached the state with proposals to help finance Boston's Central Artery project, also known as the Big Dig, through a tobacco settlement securitization.
But while Massachusetts took an innovative financing approach in 1998 by issuing grant anticipation notes, the state wants to use the settlement to "create something akin to the permanent fund that you see in other states," Stearns said.
