Michigan tobacco deal tackles default pressures
Michigan hits the market this week with $884 million of tobacco bonds in a refinancing designed to avert looming defaults.
The Michigan Finance Authority plans to price the tobacco settlement asset-backed bonds Thursday.
Jefferies is the lead manager. Citi, JPMorgan, Multi-Bank Securities, and Ramirez & Co. round out the syndicate. PFM Financial Advisors LLC is advising the state. Orrick Herrington & Sutcliffe LLP and Dickinson Wright Pllc are transaction counsel.
“Using today’s low interest rates, the MFA is undertaking a refunding that improves the likelihood that the bonds will pay according to schedule. As a result, the state increases the likelihood that the revenues currently paying the bonds will return to the state for critical programs once the bonds are repaid,” Michigan Treasurer Rachel Eubanks said in a statement. “This is our best chance at meeting both objectives.”
The bonds are backed by a portion of state-pledged tobacco settlement revenues from the master settlement agreement with tobacco companies.
Declines in cigarette use have cut into the annual payments made by tobacco companies participating in the landmark 1998 master settlement agreement with 46 states, several U.S. territories, and Washington, D.C. as compensation for government spending on health issues tied to tobacco use.
Like Michigan, many governments securitized anticipated payments but the declines have driven rating cuts and warnings of impending defaults and that’s prompted restructurings. Michigan is entitled to 4.352% of annual settlement payments.
Ohio in February refinanced more than $5 billion of tobacco debt, staving off looming defaults and restoring the bonds to investment grade. Michigan used proceeds of its issues in 2006, 2007, and 2008 issues to fund a jobs initiative and for budget relief and the bonds sold through the former Michigan Tobacco Settlement Finance Authority.
“The state has been monitoring the outstanding tobacco bonds for years and the refunding is driven by both current market rates as well as the anticipated near-term default,” the authority said.
One group of bonds totals $459 million and is being offered in several series of senior current interest and senior capital appreciation bonds with serials, terms and turbo terms with a final maturity in 2065 although that series is structured with a turbo redemption and expected average life of 16 years.
Proceeds will refund a portion of the state’s 2007 bonds and fund a senior liquidity reserve account. The bonds carry ratings of BBB-minus, BBB, A-minus, and A with the 2065 maturity not rated.
Another group of bonds selling in multiple series totaling $425 million offers senior current interest and senior capital appreciation bonds with two series offering taxables. The bonds are structured in serials, terms, and turbo terms with a final maturity 2045 although that bond has an average expected life of 13 years.
Proceeds will refund all of the state’s 2006 tobacco backed bonds, the remaining 2007 issue, and a portion of 2008 bonds. The bonds carry ratings of BBB, A-minus, and A depending on the series, with the 2045 maturity not rated.
After the deal, $5.1 billion from the 2008 issue will remain outstanding.
S&P said its ratings take into consideration the likelihood that timely interest and scheduled principal payments will be made by the legal maturity date under the appropriate rating stress level; the credit quality 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 legal and payment structures; and the availability of liquidity reserve accounts on some of the bonds.
Longer-maturing bonds were notched down due to risks posed by uncertainty over longer-term tobacco industry projections.
Strengths of the structure include liquidity reserves on some maturities, turbo redemption structures on some bonds that allow for quicker amortization, and the investment grade status of the two largest tobacco manufacturers.
Weaknesses stem from risks posed to consumption. They include the continued, and potentially greater, decline in cigarette shipments as a result of higher excise taxes imposed by the federal, state, and local governments as well as price increases by manufacturers or the passage of new regulations such as age restrictions on use or bans on menthol cigarettes. California approved such a ban and it will take effect in January.
Ongoing and future litigation risk against tobacco manufacturers and the claims challenging the MSA or qualifying statutes also pose risks that are viewed as credit weaknesses. “Although the trends over the past decade have been generally favorable, the future is uncertain,” S&P said.
The growing popularity of alternative tobacco products — the sales of which would not result in payments under the MSA — also could cut into cigarette use, S&P warns.
S&P projects annual U.S. cigarette volumes will decline by 4.00%-4.50% going forward compared to its previous annual decline assumptions of 3.00%-4.00%. The higher figure is due to the potential increase in vapor products, the high price of combustible cigarettes, and increased social awareness of the negative health effects of smoking through years of heightened regulation.
The tobacco consumption report issued last year by the Centers for Disease Control and Prevention concluded that 34 million Americans smoked in 2018, representing 13.7% of adults. That’s a decline from 14% in 2017, 15.5% in 2016, and 19.4% in 2010. Domestic volume shipment totaled 225.1 million in 2019 down from 391.3 million in 2006. Risk factors outlined in the offering statement are laid out over 20 pages and the offering statements include IHS Global’s cigarette consumption forecasts.