CHICAGO - The Michigan Tobacco Settlement Finance Authority plans to enter the market Tuesday to restructure nearly $190 million of outstanding tobacco bonds in a transaction aimed at generating $60 million to wipe out the state's current general fund deficit.
Michigan officials expect to achieve their savings goal with the refunding bonds by using a structure that pushes out the maturities of the existing taxable debt that sold in 2006, replacing it with tax-exempt bonds. The tax exemption is allowed because part of the proceeds from the original sale in 2006 - as well as the new proceeds generated from the upcoming transaction - will finance projects that qualify for tax-exempt financing under the Internal Revenue Service Code.
The transaction marks the state's third tobacco bond sale, and its first refunding of such debt.
All bonds are secured solely by a portion of Michigan's annual payments under the 1998 Master Settlement Agreement between 48 states and the major tobacco companies. Under that agreement, Michigan receives about $300 million annually. The state has issued about $1 billion of tobacco bonds, securitizing about 25% of its payments.
The upcoming deal was structured to maintain the same 13.34% securitization percentage used in the 2006 issue, said Joe Fielek, director of bureau of bond finance for the state Treasury Department.
Citi is the senior book-running manager on the deal, leading a team of six underwriters. Dickinson Wright PLLC and Dykema Gosset PLLC are co-bond counsel on the deal. Robert W. Baird & Co., and First SouthwestCo. are co-financial advisers.
Gov. Jennifer Granholm originally proposed restructuring the tobacco debt in February as part of her $45 billion, fiscal 2009 budget, which relies in part on savings from debt restructuring to avoid raising taxes in the face of the state's economic struggles. Under Granholm's proposal, the $60 million in savings would have established a fund to promote tourism across the state.
But officials recently abandoned that plan in favor of depositing the money directly into the state's general fund to aid with cash flow purposes in the current fiscal year, according to Fielek. The tourism fund "was the original plan, but we wanted to do this tax-exempt, and that wasn't eligible," he said.
The conversion is also possible because a number of the earlier projects financed with the 2006 debt qualify for tax-exempt debt under IRS code.
"We kind of knew when we first did the 2006 deal that there would be a certain number of eligible [tax-exempt] projects, but we wanted to be conservative," Fielek said.
Facing one of the weakest state economies in the U.S., Michigan continues to battle a declining housing market and rising unemployment. Despite a pair of recent tax increases, the state also faces revenue shortfalls in both 2008 and 2009. In May, fiscal officials estimated the state faces a relatively modest 2008 shortfall of $61 million. However, revenues could fall as much as $472 million short of earlier estimates in fiscal 2009, warned analysts.
The upcoming tobacco deal includes two series. The $123 million of current interest turbo term bonds are due in 2038 with a turbo redemption date of 2025. The $64.1 million in capital appreciation turbo term bonds mature in 2058 with a projected final turbo redemption date of 2032. The original 2006 structure allowed the state to put off interest payments on the CABs until 2008, and state officials expect to keep that schedule, making their first interest payment on schedule Dec. 1, said Fielek.
The bonds will benefit in part from a liquidity account with $38.8 million originally set up for the 2006 bonds. The account will be maintained for the outstanding 2006 bonds, and any amount remaining upon the final maturity of the 2008 Series A bonds will be used to pay off that remaining principal. The liquidity account will not be available for the Series B bonds, expect in the event of a default.
Fitch Ratings assigned a preliminary rating of BBB-plus to the current interest turbo term bonds, and a BBB-minus rating to the CABs. The ratings are based on the overall tobacco industry's credit quality, the structure of the MSA payments, the bond structure, and the liquidity reserve account, wrote analyst Jeffery Prackup.
Moody's Investors Service has not yet issued a rating for the bonds, though it assigned a Baa3 to the 2006 bonds. Standard & Poor's - which rated the 2006 issue BBB - has also not yet rated the bonds, though in a recent warning on the sector, the agency put 11 rated tobacco bonds, including Michigan's 2007 debt, on credit watch for a possible downgrade.
Michigan enters a market that has seen tobacco bonds grow cheaper recently, although the investor interest in the sector remains strong, according to one buyer of tobacco bonds.
"The tobacco market has demonstrated a good amount of liquidity over the last handful of weeks," said Scott Cottier, senior portfolio manager at OppenheimerFunds. "Though liquidity is fine, there has been some cheapening relative to the balance of the market, and I believe that has much to do with concern over a potential downgrade from Standard & Poor's."
For example, California's tobacco bonds maturing in 2047 were trading between $104 and $109 with yields of between 4.6% and 5.2% in January 2007. Those bonds are now trading around $89, with yields of about 6.5%. Louisiana tobacco bonds maturing in 2039 were trading for $105, with yields of 4.7% in January 2007, and are now trading for around $91, with yields of 6.5%.
"Since Michigan has sold the bonds in 2006, we've seen two major things happen in the tobacco market," Cottier said. "[Tobacco] munis have become extremely cheap to Treasuries, and credit spreads have widened dramatically."
Standard & Poor's in April put the 11 tobacco bond ratings on CreditWatch negative and revised some of its assumptions on the sector.
