In early 2003, litigation against the nation’s big tobacco companies and the fear that Philip Morris USA could be headed for bankruptcy put tobacco bond deals on ice for a while.
Time, it seems, has calmed some of those fears, and Virginia will sell its $1.1 billion of tobacco bonds tomorrow into a market much friendlier toward tobacco than it was when the state first tried in 2003.
Though marketing a tobacco deal is still a long and involved process, the strategy of selling tobacco bonds now requires fewer dealings with investors worried about the bonds’ credit, bankers and advisers said in interviews this week. The most important thing to do when planning a tobacco sale is to steer clear of the market when it is flush with tobacco paper, they said.
Two of the largest deals sold this year have been tobacco bonds, with New Jersey’s $3.6 billion sale going Jan. 23, and California’s $4.4 billion pricing March 8.Though a tough market for bond sales left large blocks of the New Jersey deal unsold at their sale-date prices, the bonds traded actively in the secondary market for weeks after the offering. A few weeks later, after investors finished absorbing the New Jersey sale, the market gobbled up California’s blockbuster deal, sold through the Golden State Tobacco Securitization Corp.
As Virginia prepares to sell $1.1 billion of debt, the state hopes to tap into the demand that met the $8 billion of tobacco bonds already sold this year, according to Steven Kantor, managing director for First Southwest Co. and Virginia’s financial adviser on the tobacco deal. He also advised on the New Jersey sale.
“That’s what we’re going to try to do — take those pockets of demand that both New Jersey and California demonstrated are out there and try to market to those sectors,” Kantor said. He said that while litigation against the tobacco companies still has the potential of souring the market, even the dispute over big tobacco’s annual Master Settlement Agreement payments doesn’t seem to worry investors.
Tobacco bonds are backed by the 1998 MSA that 46 states and six territories reached with the nation’s four biggest tobacco companies. Under the MSA, the tobacco companies agreed to pay about $205 billion over the first 25 years to compensate the governments for the care of sick smokers.
“I think that obviously having Philip Morris make the payments early this year gave the market a great deal of confidence,” Kantor said. “We went through this last year, and there was a lot of uncertainty. I think everybody is now confident with how the process works.”
On April 16, other tobacco companies withheld $696 million of their annual MSA payments, saying they overpaid in 2004. The companies withheld $755 million last year in a dispute over their 2003 payments.
Though the investor base has widened during the last eight years, many of the dominant tobacco buyers are the same ones that have were interested in November 1999 when New York City’s Tobacco Settlement Asset Securitization Corp. sold $709.3 million in the first tobacco bond deal. This might explain why the market was not adversely affected by last week’s news.
“It’s important not to abandon the core group of tobacco purchasers,” Kantor said. “We’re going to try and make this attractive to a broader perspective of buyers, but at the end of the day, we need to go back and make sure that those tobacco purchasers who have been there from day one are going to be the underlying portion of the transaction.”
Another financial adviser, who has worked on several large tobacco deals, said the market seems to be immunized to the risk of tobacco credits, which generally are rated below investment grade or close to it. This means that issuers don’t have to pay as much premium to investors in order to sell their bonds.
The drop in yields has come from a mad grab for yield in a municipal market with relatively few high-yield credits, along with an ease in risk from tobacco litigation and a generally favorable interest rate environment for issuing debt.
“It’s not like it costs you more than if you borrowed on your general fund credit,” the adviser said. “When it’s [a difference of] 200 basis points, then I can say, ‘Wow, that’s pretty costly. You’re not getting a lot for your future dollar.’ But now, it’s not that expensive.”
Virginia still wants to close its deal quickly to avoid the risk of bad news ruining its bond sale, said Evelyn Whitley, director of debt management in the Virginia treasurer’s office. In 2003, the state had to pull a $767 million deal when Philip Morris said litigation penalties might prevent it from making its 2003 MSA payment and a string of other compounding factors led to a hike in tobacco bond yields.
Virginia has received nearly $1.1 billion in MSA proceeds so far.
Senior managed by Bear, Stearns & Co., the Virginia deal will include about $628 million of taxable bonds and $477 million of tax-exempt series, according to the preliminary official statement.
Like nearly all tobacco bonds sold now, Virginia’s structure includes turbo term bonds that direct any MSA payment funds left over from semiannual interest payments to paying down the principal. The earliest tobacco deals used planned and rated maturity schedules, and underwriters also tried using super-sinker structures before the turbo bonds came into fashion, said managing director Brad Gewehr of UBS Securities LLC. UBS and its predecessor firms have worked on 24 tobacco deals, according to Thomson Financial.
First used in a tobacco deal that Bear priced for Alaska, turbos have become the industry standard. The structure of a tobacco deal now might include senior and subordinate capital appreciation bonds, serial maturities to draw interest from retail buyers, and maturities out as far as 40 years.
Bear Stearns has senior managed $24.1 billion of tobacco debt for state and local governments — the most out of any underwriter and 53% of the total par sold, according to Thomson’s data. Louisiana hired Bear to price a tobacco bond sale for it this year, but state Treasurer John Kennedy has expressed misgivings about the deal. A special panel, which includes Kennedy, is now discussing whether or not to proceed.
Bear Stearns declined to comment for this story, saying regulations prevented it from talking before Thursday’s Virginia sale.
Citigroup Investment Banking, which has managed a greater number of tobacco issues than Bear, is second as measured by total par, with $12.7 billion underwritten. Citigroup has been chosen to price about $800 million of taxable tobacco bonds for West Virginia in a deal that will likely sell by June, said James Haddon, managing director at Citigroup.
Rhode Island also is considering a new tobacco sale. Its last one, a $686 million deal, was marketed in June 2006.
Other potential deals investors are watching for the year include the refunding of Wisconsin’s tobacco bonds — $1.6 billion of which were sold in May 2002 — and a new-money transaction from Ohio. In his proposed budget, the Buckeye State’s new governor, Ted Strickland, is seeking authorization to sell up to $5 billion of tobacco bonds to help pay for new school construction and property tax relief.