CHICAGO — Minnesota aims to cast off headline risks tied to the tobacco sector next week when it sells $787.6 million of tobacco bonds by using a conservative structure that limits final maturities and ensures bondholders are paid even if cigarette consumption dips far more annually than expected.
The state also has stressed with investors that it is one of four states that entered into its own agreement with major tobacco companies to settle health care claims. Unlike the 1998 Master Settlement Agreement between tobacco companies and most states, Minnesota's agreement insulates its payments from any adjustment due to market share losses suffered by the major tobacco companies to non-participating manufacturers. No provision for the loss of market share is included in Minnesota's pact.
"Investor reaction so far has been extremely positive and the simplicity of Minnesota's tobacco agreement and the lack of a non-participating manufacturers' adjustment is resonating very well with the investor community," said Kristin Hanson, Minnesota Management and budget assistant commissioner for treasury, who along with the finance team has held meetings and calls with potential buyers.
The deal will sell in two series, one of $706.5 million of tax-exempt securities and the other of $81.1 million of taxable bonds, beginning Wednesday. The Tobacco Securitization Authority — established for the purpose of issuing the state's first bonds securitizing its settlement payments — will serve as issuer of the Minnesota tobacco settlement revenue bonds to be repaid with the state's share of settlement payments.
Barclays Capital is the book-runner. Bank of America Merrill Lynch and Jefferies & Co. are co-senior managers. Citi, RBC Capital Markets, Wells Fargo Securities, Samuel A. Ramirez & Co., and U.S. Bank round out the team.
Public Financial Management Inc. is financial advisor. Kutak Rock LLP is transaction and bond counsel. Nixon Peabody LLP is underwriters' counsel.
Following Illinois' lead in its $1.46 billion tobacco issue last year, which saw strong interest, the Minnesota deal drops the turbo redemptions, super-sinking funds and capital appreciation bonds popular in past issues in favor of a more traditional fixed-amoritization structure that offers a mix of serials and term bonds. The bonds carry a final maturity of 20 years. Illinois offered a 17-year final maturity that paid a yield of 6.2%.
The deal includes maturities in 2014 and 2015 on the taxable bonds and maturities between 2016 and 2026 on the tax-exempt piece, with a term bond tentatively set at $285 million in 2031. The bonds will feature a debt service reserve of $78.8 million.
Standard & Poor's assigned a preliminary A rating on bonds maturing from 2014 to 2022 and A-minus on bonds maturing in 2023 and after. Fitch Ratings is expected to rate the bonds BBB-plus. The bonds represent a 100% securitization of the state's tobacco settlement. "The preliminary ratings reflect our view of: the likelihood that timely interest and scheduled principal payments (sinking fund installments) will be made on each payment date and that ultimate principal payments will be made at maturity," Standard & Poor's wrote.
The state will use proceeds to pay off near-term debt service owed on various purpose general obligation debt, easing the burden on the state's general fund. Gov. Mark Dayton agreed to the financing proposed by the Legislature's Republican leaders as part of a deal to break a budget stalemate and end a government shutdown in July.
Under the budget pact, the state could sell tobacco bonds to raise $640 million for budget relief. Dayton, a member of the Democrat-Farmer-Labor Party, had pushed for an income tax increase on top earners but Republicans who control the Legislature refused. The state's use of one-shots to balance its budget contributed heavily to the loss of its triple-A ratings this year.
Minnesota has not previously leveraged its tobacco settlement payments. It was one of four states, with Florida, Mississippi, and Texas, that did not participate in the 1998 MSA. The state separately settled claims with what were then the four largest manufacturers in May, 1998, with the payments based on a formula that takes into account consumption and inflation.
The budget legislation gave finance officials some flexibility in structuring the transaction as either tobacco securitization bonds, — backed solely by tobacco company payments — or tobacco appropriation bonds — debt also backed with an appropriation pledge from the state. To tap the appropriation, however, the state must seek validation from the Minnesota Supreme Court as to the legality of using the pledge.
The upcoming issue leaves the door open for the state to eventually do so if it chooses, which would lower interest costs. It includes an extraordinary call provision that allows the state to call the bonds and pay off with appropriation-backed bonds if their use is validated. No decision has been made on whether to undertake that process. "We are focused on this transaction," Hanson said.
The transaction includes capitalized interest through Sept. 1, 2013, from bond proceeds as the legislation does not sell off the state's tobacco settlement payments until July, 2013. That means payments received until then will continue to flow to the state's general fund.
In addition to lump-sum initial payments, the state receives annual payments that have ranged from $102 million in 1998 to $169 million last year. Its highest payment came in 2007 for $184 million. The offering statement includes an October report from IHS Global Insight Inc. that forecast consumption will fall by 46% to 163 billion cigarettes in 2030 from 2010 levels of 301 billion. Declines in cigarette use accelerated in 2002 and 2003 to 3% due to rising state excise taxes. It then moderated for the next four years at a 2% rate. Consumption then dramatically declined by 4.2% in 2008, 8.3% in 2009, and 5.3% in 2010.
If consumption declines at an average rate of 3% between 2011 and 2030, debt service coverage would range between a low of 2.04 times and a high of 2.46 times. If consumption falls by 7% annually, debt service would range from 1.20 to 1.99 times. The bonds would continue to be fully paid if consumption fell by 8.03%. Bondholders would continue to receive full payments even at a 10.07 % annual drop but the debt service reserve would need to be tapped. The Illinois deal offered similar protections but its bonds could withstand the 10% decline with reserves intact.
Several buy-side participants said the deal likely would receive strong interest from buyers looking for some extra yield yet offering a more solid cushion than traditional tobacco bonds that have been battered by consumption declines, lawsuits, rising taxes, downgrades, and default warnings.
"It's well-secured," said Thomas Spalding, chief investment officer at Nuveen Investments, one of the largest holders of tobacco bonds.
While the maturity schedule and default coverage ratios are not quite as strong as what was offered by Illinois, Minnesota's deal receives a noteworthy boost due to the insulation against the NPM adjustment, said Dick Larkin, director of credit analysis at Herbert J. Sims & Co. "The cushion is a little weaker than Illinois but the fact that it's not subject to the NPM adjustment is a big factor. That's a big positive," Larkin said.
Larkin earlier this month authored a report discussing the impact of a recent development in the NPM adjustment dispute. The three largest tobacco companies last week exempted 12 states and four territories from arbitration that would force the municipalities to refund money the companies believe they overpaid in 2003. As a result, 34 other states — plus the District of Columbia and Puerto Rico — that participated in the MSA may have to do without up to $1.1 billion they otherwise would receive from the tobacco companies as early as 2013. Approximately $7.1 billion in disputed payments have been withheld for sales years of 2003 through 2010.