Tobacco Bond ‘Turbo’ Payments Lagging, J. B. Hanauer Reports

DALLAS — A J. B. Hanauer & Co. report released Wednesday found that tobacco settlement bond payments mandated under so-called turbo redemption provisions are falling behind initial projections.

The turbo provisions have become a regular feature in many bond deals sold to securitize payments to states under their landmark 1998 settlement agreement with cigarette manufacturers, often added to increase their appeal among investors.

The special mandatory redemption features, which require settlement payments that are not necessary to pay debt service in a given year be used to retire debt on an accelerated basis, were thought to offset some of the risks associated with the tobacco industry such as declining consumption, litigation, and bankruptcy.

Those turbo payments haven’t been living up to their initial expectations, according to Richard Larkin, a municipal analyst at J.B. Hanauer who authored the firm’s report.

For instance, in the case of Rhode Island Tobacco Settlement Financing Corp. bonds, for which $7.425 million of turbo payments were originally expected this year, only $3.71 million in payments have been made so far this year, according to the J.B. Hanauer report.

Other issuers have realized similar shortfalls. Turbo redemption payments in 2004 for the Puerto Rico Childrens Trust Fund tobacco bond deal so far is down 36.2% from original predictions of $14.45 million. For the New Jersey Tobacco Settlement Financing Corp. deal sold in 2002, only $18.625 million in turbo payments have been made in 2004 of the $25.74 million initially expected, a shortfall of 27.6%.

The report found that other issuers not meeting turbo redemption predictions for this year include the Washington Tobacco Settlement Authority, California’s Golden State Tobacco Securitization Corp., Alaska’s Northern Tobacco Securitization Corp., the Louisiana Tobacco Settlement Financing Corp., the Virgin Islands Tobacco Settlement Financing Corp., Wisconsin’s Badger Tobacco Asset Securitization Corp., New York Counties Tobacco Trust III, and the South Carolina Tobacco Settlement Revenue Management Authority.

“When I began looking at calls for turbo bonds, I noticed that in most cases, they weren’t being redeemed at the levels originally forecast,” Larkin said. “Granted, some are worse than others. But it didn’t take rocket science to figure out what was behind the redemption issues.”

A smoker himself who professes to doing his part in keeping cigarette consumption levels up, Larkin said that as he began to run numbers to determine where the slowdown in turbo payments originated, he found the falling use of tobacco products to be the reason behind the sluggish redemptions.

“Domestic tobacco shipment declines have averaged 4.2% a year for the last seven years,” Larkin said. “That’s well above the predictions made in 1999, the year that tobacco bond deals began coming to market. Even if things don’t get any worse, there has to be some impact to the bonds.”

Domestic shipments are the factor that drives payments to states under the terms of the 1998 Master Settlement Agreement. Those payments back the vast majority of the approximately $20 billion of tobacco bonds currently outstanding in the U.S., although about $2 billion of those tobacco bonds have a back-up pledge of state revenues.

“The fact is that the assumptions were too liberal,” Larkin said.

While turbo bonds use all surplus MSA revenues, so-called super-sinker provisions only use a portion of those overages. Larkin said that all issuers using super-sinkers met their redemption targets for 2004, but pointed out that the surpluses were nonetheless lower than originally expected.

Larkin, a former municipal analyst at Fitch Ratings, said that consumption declines are exceeding the “worst-case” scenarios used by Fitch, along with Moody’s Investors Service and Standard & Poor’s, when they first rated tobacco bonds. Many tobacco bonds have since been downgraded.

Some dispute Larkin’s assessment of falling consumption levels.

Global Insights analyst Jim Diffley said the consumption numbers he has reviewed are on track with predictions initially made by his firm, formerly known as DRI.WEFA Inc., whose forecasts have been incorporated in the official statements for many tobacco bond deals.

“All of the consumption numbers we’ve seen seem to date to be meeting projections,” said Fitch analyst Steven Moffitt. “Although there is certainly a declining trend, those numbers remain within our stress expectations,” he added.

Fitch currently maintains a stable outlook for the tobacco bonds it rates.

Don Lipkin, an analyst with Bear, Stearns & Co. agreed that turbo redemption payments for some issuers appear to be off in 2004.

While numbers Lipkin has researched indicate that shipments continue to meet expectations, he said MSA payments have been lower.

“When many of the early tobacco bonds deals were being structured, the big four tobacco companies that pay into the MSA dominated the market,” he said. “Since that time, the market share of non-participating manufacturers has increased from almost nothing to 8.1%, leaving the participating manufacturers that pay into the MSA with a diminished market share. Most tobacco securitizations assumed that the NPM market share would be static at 1.5%. This accounts for the turbo redemption shortfalls in 2004.”

The four largest companies participating in the MSA are Philip Morris USA, Reynolds American — formerly RJ Reynolds — Brown & Williamson Tobacco Holdings, and Lorillard Tobacco Co.Non-participating manufacturers do not make MSA payments to states. Instead, they make payments, based on shipments, into escrow funds held by states for a 25-year period. The escrow statutes were written to ensure that NPMs could not discount their products so significantly that they would have an unfair advantage.

“Because the NPMs have taken a bigger market share, MSA payments are lower, which is going to affect the turbos. The shortfall flows to the issues.”

Lipkin said that he believes the market will level out from the initial hits taken by the MSA participants right after the agreement was signed in 1998.

Escrow statutes, once laxly enforced, are now being more rigorously implemented because states can otherwise be penalized with lowered MSA payments. The stricter enforcement of those laws was part of the reason General Tobacco, formerly the largest NPM, signed on to the master agreement earlier this year.

“There will be some shifts in the dynamic of the market,” Lipkin said.

In addition, the numbers may be skewed because states receive MSA payments once a year, on April 15, but make two payments to bondholders a year, and the latter 2004 payment may not have been made yet, according to Lipkin. In some cases, issuers who haven’t yet made payments may be earning investment income on the monies, which can increase the size of the payments, he added.

Josh Gonze, an analyst with Thornburg Investments, said that the slower turbo redemptions reaffirm his firm’s position, which has been to avoid the tobacco sector.

“This report from J.B. Hanauer seems to indicate that Thornburg did the right thing when we decided to stay out of the tobacco sector since the firms that bought these bonds are now experiencing such issues as slower-than-expected redemptions,” Gonze said.

B. Clark Stamper, president of Stamper Capital & Investments, said that bondholders who buy turbo bonds have always understood the risks associated with them.

“Even if they don’t pay off on schedule, they’re still going to pay off ahead of their scheduled maturity,” Stamper said. “If they don’t, that’s okay too. These things have a claim into perpetuity, so no matter how much payments slow down, these bonds will pay as long as people smoke in the United States.”

Tobacco bonds are trading more often, and at better rates, than earlier this year, said Michael Marz, the vice-chairman of First Southwest Co. Tobacco bonds traded yesterday at yields of 6.9% to 7.1%, and trades have been occurring more frequently than they were last year.

Lipkin said he continues to believe that litigation is the greatest risk to tobacco bonds. Last week, he released a report on lawsuits like the one brought by non-participating manufacturer Freedom Holdings against the state of New York.

Because that lawsuit challenges the validity of the escrow statutes that force NPMs to pay into escrow funds, it could, if successful, nullify those laws. If that happens, Lipkin said, NPMs would be able to offer even deeper discounts for their product, which could ultimately pull market share away from participating manufacturers and drive down MSA payments to states even further.