New Law Snuffs Out Tobacco Rally

Legislation authorizing the U.S. Food and Drug Administration to regulate cigarettes beat back a rally in tobacco bonds this month.

President Obama on Monday signed into law the Family Smoking Prevention and Tobacco Control Act, which enables the FDA to limit tobacco marketing and mandate bigger warning labels.

More than 1,000 organizations endorsed the law, including national public health, regional, and religious organizations. Tobacco bondholders were not among the supporters.

Just as the sector was on the mend, the legislation knocked tobacco bonds back to the floor.

"My immediate reaction is, 'Bad news for bondholders,' " said Dick Larkin, director of credit analysis at Herbert J. Sims & Co.

The reason bondholders might wring their hands about a law designed to keep children from smoking is the 1998 settlement between 46 states and the four biggest tobacco companies.

Under the Master Settlement Agreement, the biggest civil settlement in U.S. history, the tobacco manufacturers agreed to pay billions of dollars a year in perpetuity in return for immunity from liability from the states.

Many states have securitized these settlement payments, or sold to bondholders the right to receive future cash flows from the MSA. Investors own about $36 billion in tobacco bonds.

Payments under the MSA - and consequently the value of tobacco bonds - can go down if cigarette sales volume declines.

At last count, the Tobacco Tax Bureau estimated cigarette consumption is declining 3.7% a year.

Larkin, who already expected shipments to drop 9.6% this year because of new taxes on cigarettes, said this legislation could further choke consumption.

"This certainly is not going to make it better," he said. "I don't see anything in here that says more people will smoke because of it."

The bond market clearly agrees. Tobacco bond prices, which rebounded from their lows earlier this spring, have been pushed back down as the prospect for redemptions dims.

Yesterday, a customer bought a Buckeye Tobacco Settlement Financing Authority bond with a 2047 maturity at a yield of 9.55%, according to Municipal Securities Rulemaking Board data.

Earlier this month, the bond traded at a yield as low as 8.71%.

On Monday a customer sold a New Jersey Tobacco Settlement Financing Corp. bond maturing 2039 at a yield of 9.75%, up from 9.08% in early June.

Phil Fischer, municipal strategist at Bank of America-Merrill Lynch, wrote in a report last week tobacco bonds fell 3.5% from the end of May through June 18.

This is not entirely because of the legislation. Bonds generally have given back some of their gains amid rising interest rates and inflation expectations.

Baa-rated munis at the 30-year point of the Municipal Market Data yield curve scale added 23 basis points in the last month.

Buck Stevenson, a high-yield muni portfolio manager at Silvercrest Asset Management, said the high-yield sector is weaker by 10 to 25 basis points the past few weeks.

Tobacco bond yield ascensions in excess of that could be attributed to the legislation, he said.

Stevenson does not like tobacco bonds. Investors in this sector have to worry about unpredictable courtroom verdicts and a government intent on controlling the industry, he said.

This legislation further damages the sector's appeal, Stevenson said, by muzzling tobacco companies' advertising.

"This legislation is going to make it more difficult for tobacco companies to market cigarettes," he said. "Kids are going to be more aware of the dangers, thereby consumption is going to continue to drop at a quicker pace than was forecast."

Not everyone sees this legislation spelling doom for tobacco bonds.

James Colby, head of municipal strategy at Van Eck Global, said diminishing usage of cigarettes will hurt tobacco bonds in the long run. That has been the trend for years.

Merely formalizing the FDA as a regulator of the industry does not change much, Colby said.

"It's just another brick in the wall," he said. "I don't see this as having a major impact residually on us as buyers of tobacco bonds."

Colby acknowledged that tobacco-bond yield spreads have widened, but said it has mostly not been dramatic.

Van Eck's high-yield exchange-traded fund owns a few tobacco bonds, including issues from the Inland Empire Tobacco Securitization Authority and the Virginia Tobacco Settlement Financing Corp.

Jay Abrams, head of credit analysis at FMSBonds Inc., also does not see this law tolling the death knell for tobacco debt.

If anything, it may actually protect bondholders by curtailing the number of lawsuits facing tobacco companies. It also places the industry under federal regulatory control, which could dissuade states from imposing state-by-state controls that could be more onerous, Abrams said.

The provisions of the bill could not be so bad for the industry. Philip Morris USA supported it, and reportedly helped write it.

The bill has drawn criticism for potentially cementing Philip Morris' 50.7% share of the U.S. cigarette market by erecting barriers to entry for new and smaller competitors.

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