Already enjoying a good run, tobacco settlement revenue bonds got a boost last Friday when a federal appeals court ruled in favor of cigarette-makers charged in the U.S. governments civil racketeering suit, removing some of the litigation risk the sector faces.
The immediate reaction to the ruling which stated that the government cannot force the industry to give up $279 billion in past profits for allegedly hiding the health dangers of smoking was a 20 to 25 basis point drop in tobacco bond yields, as their prices soared.
This pushed the spreads between high-grade tax-exempt securities and municipal bonds, backed by payments tobacco companies make to state and local governments under the 1998 Master Settlement Agreement, to new 12-month lows, according to Legg Mason Wood Walker Inc.
The ruling by the U.S. Court of Appeals for the District of Columbia is a big win for tobacco companies because it removes at least for now the largest potential financial threat that the industry would face if found guilty in the racketeering suit the U.S. Department of Justice is pursuing.
The markets see this decision as removing a hurdle to a more favorable litigation environment overall for the tobacco companies, said Amy Castleberry, an assistant vice president and analyst at Legg Mason.
She said the decision also supported tobacco bond prices because cigarette makers would likely have found it difficult to meet their MSA payment obligations if faced with such a large penalty. State and local governments have sold $26.8 billion in revenue bonds backed only by future MSA payments most of which are tax-exempt, according to Thomson Financial.
While the racketeering suit proceeds and the government decides whether to appeal the ruling, tobacco bonds are enjoying the ride.
For example, bonds issued by Californias Golden State Tobacco Securitization Corp., which have a 6C\v coupon and mature in 2039 traded Tuesday at an average price of 103.45 per $1,000 of face value and a yield of 6.20%. The day before the ruling, the price was 101.58 and the yield was 6.50%, according to Municipal Securities Rulemaking Board data. Over the same period the yield on 30-year triple-A bonds as measured by Municipal Market Data fell only 13 basis points.
A lot of price movement and event risk has been linked to litigation from the moment the sector came about when the first deal was sold in 1999, said R.J. Gallo, a portfolio manager and analyst at Federated Investors Inc., which have some exposure to tobacco bonds. There is no doubt that it was the most positive outcome at the appeals court level on the issue of disgorgement [of past tobacco companies profits]. Now the Department of Justice case has largely lost its teeth, though there is no complete certainty because the ruling could be appealed.
The government has until March 19 to decide if it wants to appeal. If that happens the issue of a potentially large penalty could be cracked open again, Gallo said.
Right now we are on the upswing, but weve seen upswings before, Gallo said. There is no doubt that there seems to be a long-term decline in the level of litigation risk, but it is still substantial. I dont want to understate it, it was a big positive for tobacco and the market reaction was justified. [But] I think that lingering uncertainty has to cap the upside to some degree.
Investors, who buy municipal bonds backed by MSA payments, have to be content with the fact that major players in the tobacco industry are battling billion dollar suits in Illinois and Florida, known as the Price and Engle cases respectively, and a group of small tobacco manufacturers lead by Freedom Holdings is challenging the legality of the MSA in New York.
Gallo said the fact that rating agencies have not taken any action since Friday on tobacco settlement revenue debt is also indicative of remaining risks. Moodys Investors Service rates various tobacco bonds from Baa1 to Ba2. Standard & Poors maintains a negative outlook on the sector and rates bonds between BBB-plus to BBB-minus and Fitch Ratings rates the industry BBB-minus.
But Ronald Fielding, who manages the high-yield Rochester National Municipals Fund at Oppenheimer Funds Inc., said he remains cautiously optimistic.I expect tobacco bonds to continue to do fine this year, he said. The Department of Justice case is effectively settled without financial costs to tobacco companies. Freedom Holdings is still a major case and Engle in Florida and Price in Illinois still need to be settled and Im optimistic that they eventually will be settled, although Im sure there will be some bad news along the way.
He said the sector is in a good shape from the technical standpoint because there are only a few potential deals so far on the horizon. Colorado was considering issuing up to $850 million of tobacco settlement backed bonds this year and The Bond Buyer reported earlier that Virginia could consider moving forward with its stalled $700 million tobacco bond transaction.
Fielding also said he still sees relative value in the sector even though prices have risen substantially and spreads narrowed.
For example, Golden State bonds yielded as much as 340 basis points over 30-year triple-A bonds, when the average inter-dealer price dropped to its lowest point in September of 2003. Now that difference has shrunk to 190 basis points.
People are getting far more used to the credit and credit spreads have narrowed significantly, particularly in the fourth quarter and in January this year, but there is still a fair amount of room to go before they equal other triple-B revenue bonds in yields, so we are still optimistic, Fielding said.
The narrowing of spreads is only partially dependent on a decline in litigation risk, most analysts attribute it to a general credit spread compression that the market experienced last year, as investors sought out any higher-yielding bonds to generate income while the overall interest rate level remained low.
But Josh Gonze, credit analyst with Thornburg Investment Management Inc., said this trend cannot continue forever. We noticed that spreads compressed on tobacco bonds after that court decision that removed one litigation threat, but most of the risks facing tobacco bonds were not affected and I dont see any further compression, he said. Eventually, I expect spreads to widen.
If that happens, people who do own tobacco bonds will see poor returns, he said.
Although tobacco bonds have done very well so far this year and last, Peter DeGroot, a municipal bond strategist at Lehman Brothers, said that over a longer period of time their performance is not so impressive.
Last year, tobacco bonds in the Lehman Brothers Municipal Bond Index returned 8.30% compared to 6.37% for similarly structured bonds in the index. But since 2003, tobacco bonds actually underperformed their triple-B rated peers. Using a metric that takes into account volatility and total return since 2003 the Sharpe ratios tobacco bonds were also less appealing than other triple-B rated bonds, he said.
According to Gonze, high risk and volatility associated with tobacco-settlement bonds are among the reasons why Thornburg Investment Management does not own any bonds backed by MSA payments and that is exactly what makes its funds attractive to investors who want to avoid tobacco risk.
I dont see one court decision that will make tobacco risk-free, he said.
But for many investors this risk is justified, even though tobacco bonds are not as cheap as they were in 2003 and the middle of last year. With high grade long-term bonds yielding just 4.30%, bonds backed by MSA payments are still attractive because of coupon income. Gallo said that crossover accounts could have used the latest uptick in tobacco bond prices to sell their bonds and book profits, but portfolio managers probably held on to them.
DeGroot said thats because its hard to find a suitable substitute for them. These securities do supply a significant amount of income, he said. If you do sell this security, youve got to consider your options of trying to replace that yield and the options are relatively limited in our market, he said.
