CHICAGO – After long eyeing a current and advance refunding for savings, Illinois’ Railsplitter Tobacco Settlement Authority is making its move this week ahead of the expected elimination of advance refundings.

The special purpose authority established to securitize the state’s tobacco settlement payments in a $1.5 billion transaction in 2010 is slated to price Wednesday $679 million of bonds to refund a portion of the original deal. About $385 million of the original debt will remain outstanding.

The 2022 to 2027 maturities of the asset-backed securities are preliminarily rated A by S&P Global Ratings with the final 2028 maturity rated A-minus. S&P affirmed its rating on most of the 2010 tranches at A in 2015 and raised two to A from A-minus, with the original 2028 maturity left at A-minus.

Bonds backed by the tobacco Master Settlement Agreement

Jefferies has the books with Ramirez & Co. Inc. and Siebert Cisneros Shank & Co. LLC as joint book-runners. Stifel Nicolaus & Co. Inc., Loop Capital Markets, and Morgan Stanley are co-senior managers with another five firms rounding out the syndicate as co-managers.

Acacia Financial Group Inc. is advising the state and Orrick, Herrington & Sutcliffe LLP is bond counsel.

A big portion of the deal is a current refunding so there was no rush, but a portion will advance refund bonds and the tax reform package that has advanced in Congress would ban such financings going forward so the state was under the gun to act.

“Everything that’s in the money is in the deal and there are big savings and it’s better to do this sized deal than to do in pieces,” said one market participant, who estimated the overall savings in the double-digit range.

The original, later maturing bonds carry interest rates in the 5% to 6% range. The conservative structure and the market’s appetite for higher yield bonds should drive appeal, said one market participant.

The state confirmed in the fall 2016 that it was discussing tobacco refunding opportunities with bankers and earlier this month disclosed its intent to refund up to $800 million in a posting on the Municipal Securities Rulemaking Board’s EMMA website.

The preliminary offering statement and investor presentation was published Friday.

The original conservative structure ensured bondholders would be repaid even if cigarette consumption fell annually by 10% in future years amid rising tobacco taxes and local government and state actions to ban or limit smoking and raise the legal smoking age. Consumption decreases at the time had been forecast at a cumulative average of about 3% going forward after a steep 9.3% decline in 2009.

The state dropped the turbo redemptions, super-sinking funds and capital appreciation bonds popular in earlier deals in the tobacco securitization sector in favor of a more traditional tax-exempt structure that offered a mix of serials and term bonds limited to a 17-year maturity.

It also provided a significant cash cushion in debt-service coverage ratios and a reserve that was funded at $146 million. The structure eased market concerns over future default projections that earlier deals from other states faced.

One structural change in the upcoming sale is a modification of the debt service reserve requirement in the indenture that will reduce the size of the reserve to $140.8 million, lead banker on the deal Kym Arnone of Jefferies said in the recorded investor presentation. Excess funds will be released to the state.

Illinois used roughly $1.3 billion from the 2010 sale to pay off a backlog of fiscal 2010 bills as it then grappled with a $12 billion deficit. The deal marked the state's first and only issue securitizing its share of payments under the 1998 Master Settlement Agreement between 46 states and most major tobacco companies.

The Railsplitter authority purchased all of the state's assets from the agreement and all payments were pledged to bondholders. Payments under the MSA are based on a complex formula adjusted for the size of the cigarette market, inflation, consumption, and other factors.

IHS Global Inc.’s latest forecast projects annual consumption declines in the 3% range until 2024 when they fall into the 2% range. Pledged revenues in 2018 are estimated at about $325 million providing 2.36 times coverage on all bonds. Debt service coverage hits 3% in 2027 and then 10.39 times in 2028.

Steady declines of 40.8% in the early years to 20.5% in the later years would have to occur for a default to trigger a default.

IHS projects an average annual decline of 3.1% from 2017 to 2028 with consumption falling a cumulative 31% from the 177.3 billion cigarettes currently being consumed.

IHS’ model is based on formula that looks at projected annual population growth, price growth of cigarettes with a 1% increase in price resulting in a consumption decline of .33%, disposable income, projected youth consumption and the impact of health warnings, public bans, smokeless tobacco products use, and the negative impact of taxes.

“The biggest factor in our model is the increased health awareness of the population as to the dangers of cigarette smoking,” James Diffley, a senior director at IHS, said during the recorded investor presentation.

The bond ratings reflect the issuance of asset-backed securities transaction backed by tobacco settlement revenues, resulting from the master settlement agreement payments, fully funded liquidity reserve account, and interest income, S&P said.

“The preliminary ratings reflect our view of the transaction's senior liquidity reserve account and legal and payment structures, among other factors,” S&P wrote in the Friday report.

The preliminary ratings reflect the likelihood that timely interest and scheduled principal payments will be made at each bond's maturity, the credit quality of the two largest participating tobacco manufacturers, which are Altria Group Inc., parent of Philip Morris USA Inc. and British American Tobacco PLC (BAT), parent of Reynolds American Inc.

A strength is the structure which allows the series 2017 preliminary rated bonds to withstand an approximately 18.3% year-over-year decline in cigarette consumption. Weaknesses include continued, and potentially greater declines in cigarette shipments as a result of higher excise taxes imposed by the federal and local government, price increases by manufacturers, or the passage of new regulations.

Other risks include the U.S. Food and Drug Administration announcement of a multiyear plan to significantly reduce addictive nicotine in combustible cigarettes, litigation risk against tobacco manufacturers and claims challenging the MSA or qualifying statutes, and the increase in the popularity of alternative tobacco products, the sales of which would not result in payments under the MSA.

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