While Pennsylvania's $1.4 billion sale of tobacco bonds looms as attractive for investors, the transaction raises more smoke alarms about the commonwealth's budget practices.

Against a backdrop of persistent budget strife, Jefferies was set to price the Commonwealth Financing Authority’s Series 2018 tobacco master settlement bonds Wednesday. However, market sources indicated the deal was moved to the day-to-day schedule Monday.

Under a 1998 landmark agreement, tobacco companies make annual payments to the 52 states and territories signing on to it in perpetuity in return for dropping any future legal claims against the tobacco manufacturing companies.

Gov. Tom Wolf and Pennsylvania lawmakers signed off on the bond issuance in October to cover a $2.2 billion budget gap. In early July he allowed the state budget to become law without his signature, prompting a four-month give-and-take with state lawmakers over the revenue to fund it. The budget deal also included casino gambling expansion.

“Despite the one-time nature of the commonwealth's negative general fund beginning balance, this planned borrowing to offset this balance constitutes deficit borrowing,” S&P Global Ratings analyst Carol Spain wrote in a presale report.

Spain said misalignment of ongoing revenues and expenses -- missed revenue estimates of $1.1 billion and cost overruns of $400 million -- as contributing factors.

S&P and Moody’s Investors Service rate the tobacco bonds A and A1, respectively, both with stable outlooks. Fitch Ratings assigns an A-plus rating with a negative outlook.

"It's still a concern that the state is doing this to plug a budget hole," said Alan Schankel, a managing director at Janney Capital Markets.

Alan Schankel of Janney Capital Markets expects "robust" retail demand to compliment strong institutional demand on Illinois GOs
Alan Schankel

Still, the deal should appeal to investors, said Schankel, who cited debt service coverage of roughly 3 times and the state's appropriation backing. Many traditional tobacco sales are high-yield.

Pennsylvania's share of annual payments under the settlement will secure the bonds. Serial maturities will run from 2020 to 2039.

"It's a strong deal and there will be a lot of interest when it prices," said Schankel.

Over the last five years, the commonwealth has realized $320 million annually on average through the settlement.

Pennsylvania has received a rash of rating downgrades over the past three years, most recently in September when S&P lowered Pennsylvania’s general obligation rating to A-plus. Fitch Ratings and Moody’s rate the GOs AA-minus and Aa3, respectively.

Wolf, a Democrat seeking re-election who must work with a Republican-dominated legislature, is expected to present his fiscal 2019 budget early next month.

“Fiscal stability will likely be short lived, in our view, as we anticipate that the commonwealth will again face a significant budget gap in fiscal 2019, and given thin margins and reserve levels, even a small deviation in revenues or expenditures could lead to a general fund deficit,” said Spain.

Pennsylvania’s nonpartisan Independent Fiscal Office projected that only $216 million of the $2.3 billion of new general fund revenues will recur the following year, with declining recurring revenue thereafter. IFO envisions a $988 million, or 2.9%, deficit for fiscal 2019.

“We anticipate that lawmakers will again face difficult and possibly protracted budget negotiations,” said Spain.

Turf battles at the state capitol in Harrisburg have gotten tiresome, said Villanova School of Business professor David Fiorenza.

“Pennsylvania voters are concerned about whether their taxes will increase and do not want to hear about the lawmakers’ childish sandbox disagreements,” said Fiorenza, a former chief financial officer of Radnor Township, a Philadelphia suburb.

Another warning sign for Pennsylvania down the road came last week with a report commissioned by state Treasurer Joe Torsella saying insufficient retirement savings could cost the commonwealth $14.3 billion in state assistance by 2030.

The study, by Econsult Solutions Inc. of Philadelphia, determined that the commonwealth spent an estimated $702 million in public assistance costs and lost about $70 million in tax revenue in 2015 due to insufficient retirement savings by state residents.

These amounts, said Torsella, are projected to spike to $1.1 billion in extra public assistance costs and $106 million in lost revenue in 2030, for a total of $14.3 billion by 2030.

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