S&P Downgrades 16 Tobacco Deals to Junk

Standard & Poor’s knocked almost half the tobacco bond universe down to junk on Thursday as it surmised many of these structures would not be able to withstand a severe cutback in smoking.

The rating agency downgraded 16 tobacco securitizations with about $22 billion of face value.

Most tobacco bonds have for a while been rated BBB by S&P — on the precipice of investment grade. This downgrade junked many of them.

The three biggest tobacco securitizations — the $5.53 billion Buckeye Tobacco Settlement Financing Authority deal from Ohio, the $4.45 billion Golden State Tobacco Securitization deal from California, and the $3.62 billion New Jersey Tobacco Settlement Authority deal — were all downgraded, with most CUSIPS falling from investment grade into speculative grade.

The downgrades derive from changes in the methodology Standard & Poor’s uses to determine the risk of a tobacco bond defaulting.

The revision, which was announced in August, was that smoking will decline 5-6% in 2010, compared with the initial assumption of 3.5%.

This assumption, along with some others, suggested greater stress on securitized structures relying on payments from the 1998 Master Settlement Agreement.

In 1998, 46 state attorneys general cut a deal with cigarette manufacturers. In exchange for immunity from state lawsuits, the tobacco companies would pay the states billions of dollars a year in perpetuity.

Under the settlement, the tobacco industry was expected to pay the states more than $200 billion over the first 25 years.

Rather than collect the money spaced out over all that time, many states and some local governments opted to sell the rights to receive the payments. They issued bonds the interest and principal payments on which were supported by the settlement payments expected to be received from the cigarette companies.

There are about $55 billion of securitized tobacco bonds outstanding, according to Bloomberg LP.

Like any securitization, these structures attempted to set interest and principal payments that could be covered by the money generated from the securitized collateral.

The risk to the bondholder is if the actual cash flows fall short of the projections by a magnitude that leaves the structure without enough cash to cover debt service.

In other words, the risk to tobacco bondholders is if tobacco companies end up paying less to states than expected.

Because the amount of money that manufacturers pay states is very difficult to predict, Standard & Poor’s gauges the risk of tobacco structures by submitting them to theoretical stress tests under which cash flows are much less than expected.

It imagines whether a deal would be able to repay bondholders in the most likely situation, as well as very unfavorable, and less likely, situations.

Some of these tobacco structures did not survive the very unfavorable situations, or “stress cases.”

“These classes rely more heavily on more favorable industry conditions and the outcomes of events that are difficult to predict,” Standard & Poor’s analysts wrote in a report explaining the downgrades. “This sensitivity is not consistent with our definition of an investment-grade rating.”

Not all tobacco bonds flunked the stress tests under the revised assumptions. Standard & Poor’s affirmed ratings, mostly investment grade, on about $13.8 billion of tobacco bonds.

Which bonds passed the test squares with what market participants have long recognized: tobacco bonds underwritten earlier last decade are safer than ones underwritten during the credit bubble.

Most tobacco bonds hit the market in one of two major waves: the first in 2003, and the second beginning in 2005 and cresting in 2007.

The bonds from the first wave generally left themselves much bigger cushions, meaning they could withstand a greater decline in settlement payments before defaulting. The expected cash flows generated from the settlement were a lot more than the cost of debt service.

The bonds from the second wave left themselves less of a cushion.

The weighted average dated date of the downgraded bonds is 2006. The weighted average dated date of the bonds that sidestepped a downgrade is 2004.

The formula establishing how much manufacturers pay to states is extraordinarily complicated, but the thrust of it is the companies have to pay less if people smoke fewer cigarettes.

With a bombardment of excise taxes having been placed on tobacco products in recent years, that is exactly what is happening.

Americans smoked 325 billion cigarettes last year, according to the National Association of Attorneys General. This marked a 9.3% plunge from 2008 and a decline of 4.3% annually over the past five years.

The sharp downdraft in cigarette use was reflected in the payments the tobacco companies made to the states this year: $6.39 billion.

That represents a dive of 16.5% from last year and badly misses the “base” scenario of $8.14 billion contemplated when the settlement was first reached.

The second wave of tobacco bonds typically assumed only a 4% decline in smoking annually, Standard & Poor’s wrote.

“The cash flows available for the transactions, especially those originated in 2007, were sensitive to the actual volume declines in cigarette consumption during the year 2008 and 2009, and the revision in our cash flow assumptions,” Standard & Poor’s wrote. “The payments in these transactions fell behind their original projections.”

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