Massive Ohio tobacco bond refunding takes Buckeye credit off default track

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Ohio is pricing $5.2 billion of tobacco refunding bonds next week to restructure debt that would otherwise begin to default within four years in a deal that brings the credit back to investment grade.

The Buckeye Tobacco Settlement Financing Authority sale is expected to refund all but $230 million of the bonds the authority issued in 2007, according to the Ohio Treasurer’s office.

"The coupons are going to be significantly lower from what they were earlier,” said Tozar Gandhi of IHS Markit.

“By taking advantage of the current record-low interest rate environment, we’re creating a more resilient bond structure," said Ohio Treasury spokeswoman Brittany Halpin. "Today’s action will preserve the opportunity for Ohioans to benefit from this (tobacco) settlement in the coming years.”

To maximize investor participation, the sale will include a mix of roughly $327 million taxable bonds and $4.8 billion of tax-exempt debt, creating a $5.2 billion deal that makes it one the biggest tobacco deals to come to market as of yet, according to Tozar Gandhi at IHS Markit.

S&P Global Ratings assigned various investment-grade ratings to many of the new bonds, ranging from BBB-plus to A depending on the seniority and maturity, according to bond documents. The outstanding bonds are rated B-minus and CCC-plus.

The transaction also includes a $3.4 billion tranche of non-rated bonds maturing in 2055.

S&P said that the ratings reflect its view of the likelihood that timely interest and scheduled principal payments will be made by the legal maturity date under the appropriate rating stress level. It also takes into account the credit of the two largest participating tobacco manufacturers: Altria Group Inc., parent of Philip Morris USA Inc., and British American Tobacco PLC, parent of Reynolds American Inc. The S&P ratings also reflect the transaction's legal and payment structures and the liquidity reserve subaccounts.

Gandhi said that based on the initial prospectus the coupons on the taxable bonds are going to be in the 1.5% range. “So the coupons are going to be significantly lower from what they were earlier,” he said.

Josh Ippolito at IHS Markit said there has been a wide appetite for tobacco bonds and in the last month or two, investor interest in taxable tobaccos has skyrocketed with prices jumping six or seven points within the last month to six weeks. "So that is why you see a taxable portion in the new Buckeye deal," Ippolito said.

The original Buckeyes priced with low investment grade ratings in 2007 but the bonds fell well into junk-bond territory because domestic cigarette sales volumes declined. The state said it was projecting the first default on the 2007 bonds, based on current tobacco consumption trends, to come as soon as 2024.

The refunding bonds are secured by cigarette industry payments that 46 states as well as Washington, D.C., and five U.S. territories receive annually via a landmark 1998 master settlement agreement (MSA) that tobacco companies reached with attorneys general nationwide. The payments are as compensation for local government expenses stemming from health problems related to tobacco use.

The state did not add any special credit enhancements to the bond refunding and the structure will not push out the term of the bonds.

Jefferies LLC and Citigroup Global Markets are co senior managers. Orrick, Herrington & Sutcliffe LLP and Squire Patton Boggs LLP are co-bond counsel. PFM Financial Advisors LLC is the municipal advisor.

Daniel Urbanowicz at Ziegler Capital Management said Ohio has structured its deal to include a huge range of buyers, as it includes taxable and tax-exempt bonds, rated and unrated debt, maturities ranging from less than 6 months to 37 years, and a variety of structures, including serial, term, turbo term, and capital appreciation bonds.

Ted Swinarski, head muni trader at FMSbonds, said low rates and the compression of yields compared to historic levels means the bonds should be easily absorbed. Swinarski cited this week’s Stevens Institute of Technology’s $172 million of revenue bonds issued via the New Jersey Educational Facilities Authority as an example of similarly rated bonds that were well received by investors. “These bonds are BBB-plus rated and they come in 3.0% and 3.03% for paper maturing in 2040s,” Swinarski said. “That is why I think low rates are making this possible.”

Swinarski said that the impact of the transaction is not only its size but also the amount of paper that it will take out of the high-yield market.

Urbanowicz said the refunding could further compress spreads in the high-yield space.

“The securities that are going to get called in from this new issue obviously have been Caa1 and B3 rated, depending on what series you have had out there, for a number of years,” he said. “This refinancing will clean all that up and it will take out all of those securities that range from 5.18% that were due in 2024 all the way to the 6.5% that were due in 2047."

Demand for high-yield munis has been insatiable as investors hunt for yield in the low rate environment, which has led to spreads being compressed to historic lows, Urbanowicz said. "Being that a portion of this deal is investment-grade and refunding high-yield positions currently in the market, high-yield investors will be forced to replace those positions, which will drive spreads even lower. The current market clearly favors issuers as rates remain low and demand has driven down spreads."

Ippolito said that the maturities that are going to be called are all trading just above par. “You have two zero coupons that are trading actively near there accreted value and you have the one remaining bond that will seemingly remain outstanding and that has not traded but it has been bid higher significantly in the last few days,” Ippolito said.

Ippolito said he expected to see more refundings to follow. "There are just too many high-coupon bonds out there for that not to happen," he said.

Annual MSA payments are subject to inflation adjustment with a floor of 3%. Since 1999, 21 states and territories have securitized the MSA payments by selling tobacco bonds or transferring their rights to the MSA payments for an upfront fee.

Possible risks to the sector include the chances of greater-than-expected consumption declines; the possible bankruptcy of a tobacco company; failure of the states to enforce qualifying statutes; and the extension of prepayment risks.

In 2018, New Jersey made a similar move to restructure its tobacco bonds into investment-grade paper.

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Buckeye Tobacco Settlement Financing Authority Refunding bonds Ratings Ohio Primary bond market Unrated bonds
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