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Recent Tobacco Bond Offerings Build In New Protections

By: Neuberger Berman
Harvest Exchange
April 30, 2018

Recent Tobacco Bond Offerings Build In New Protections

“Giving up smoking is the easiest thing in the world. I know because I’ve done it thousands of times.” — Mark Twain

Tobacco settlement securitization bonds are issued by states to monetize future payments from tobacco companies to help defray tobacco-related state health care costs. Although we do not favor investment in the sector for capital preservation strategies, it remains an interesting area that offers diversification and sometimes attractive relative value.

The last few months have seen an uptick in underwriting, with settlement bond issuance from Illinois, New Jersey, Pennsylvania and San Diego. Both New Jersey and San Diego transactions were full refundings of existing bonds, Illinois came to market with a partial refunding, and Pennsylvania issued new money bonds to balance its annual budget. Although these issuers came to the market for different reasons, one common theme across transactions was an increase in bond-holder security.

For example, New Jersey’s newly issued senior bonds can withstand 8.7% annual declines in cigarette consumption and still have enough cash from the Master Settle Agreement (MSA) payments, created under the 1998 litigation settlement between 48 states and the four largest tobacco companies, to meet all scheduled principal and interest payments. In contrast, New Jersey’s 2007 tobacco settlement bonds will not be able to meet their final scheduled senior principal and interest payments in 2041 given estimated annual cigarette usage decline rates of 3%. The original structure of the deal allowed the bonds to withstand annual decline rates of 3.97%.

Other recent transactions have incorporated increased “breakeven” decline rates; for example, San Diego senior bonds can tolerate a 10.8% annual decline and Illinois senior bonds a 20.6% annual decline. Pennsylvania went so far as to pledge an annual appropriation from the state in the event MSA payments are ever insufficient to meet scheduled principal and interest demands. The increase in bond-holder security coincides with greater volatility surrounding consumption.

Recent Cigarette Usage Trends

Source: U.S. Department of Treasury, Alcohol and Tobacco Tax and Trade Bureau.

Reasons for the Decline

Consumption rates have decreased in recent years as a result of many factors: Consumer disposable income has decreased in the face of higher gasoline prices; tobacco companies have focused on higher pricing rather than pushing volume amid corporate consolidation; several states have raised taxes on tobacco products; and alternative tobacco products (e.g., e-cigarettes) that fall outside the MSA have drawn market share, particularly among young people.

IHS Global, a leading econometric and forecasting consultant, expects that the long-run annual average cigarette decline rate will be 2.9%, although we anticipate more volatility than this figure lets on. Tobacco companies have sizable product backlogs that are awaiting FDA approval, not all of which may be included in MSA payments. Over time, we think localities will likely decide to increase tobacco taxes, leading to sizable sequential declines in usage. There is also potential for more regulation and litigation that could decrease revenues into the MSA. All of these issues create the potential for downside shocks to consumption that would be in excess of the long-term decline average.

Investment Perspective

Finding value in this sector requires a combination of analyzing sector fundamentals, running multiple scenarios to determine how the bond Incomestructure reacts to changes in the underlying assumptions (e.g, senior vs. subordinate lien, serial vs. turbo structure) and evaluating the relative value of each bond. The recent tobacco transactions offer a higher tolerance for usage declines, especially in shorter-duration tenors that can withstand substantially higher breakeven rates, potentially providing an opportunity to participate in a historically high-yielding sector, assuming that the risk-reward tradeoff is acceptable to the investor.

This material is presented solely for informational purposes and nothing herein constitutes investment, legal, accounting or tax advice, or a recommendation to buy, sell or hold a security. No recommendation or advice is being given as to whether any investment or strategy is suitable for a particular investor. It should not be assumed that any investments in securities, companies, sectors or markets identified and described were, or will be, profitable. Information is obtained from sources deemed reliable, but there is no representation or warranty as to its accuracy, completeness or reliability. All information is current as of the date of this material and is subject to change without notice. Any views or opinions expressed may not reflect those of the firm as a whole. Publications and websites referenced herein are intended solely for your information and should not be construed as an endorsement by Neuberger Berman. Neuberger Berman is not responsible for the content of these publications or websites.

Certain products and services may not be available in all jurisdictions or to all client types. Indexes are unmanaged and are not available for direct investment. Investing entails risks, including possible loss of principal. Past performance is no guarantee of future results.

A bond’s value may fluctuate based on interest rates, market conditions, credit quality and other factors. You may have a gain or a loss if you sell your bonds prior to maturity. Of course, bonds are subject to the credit risk of the issuer. If sold prior to maturity, municipal securities are subject to gain/losses based on the level of interest rates, market conditions and the credit quality of the issuer. Income may be subject to the alternative minimum tax (AMT) and/or state and local taxes, based on the investor’s state of residence. High-yield bonds, also known as “junk bonds,” are considered speculative and carry a greater risk of default than investment-grade bonds. Their market value tends to be more volatile than investment-grade bonds and may fluctuate based on interest rates, market conditions, credit quality, political events, currency devaluation and other factors. High-yield bonds are not suitable for all investors and the risks of these bonds should be weighed against the potential rewards. Neither Neuberger Berman nor its employees provide tax or legal advice. You should contact a tax advisor regarding the suitability of tax-exempt investments in your portfolio.

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Originally Published at: Recent Tobacco Bond Offerings Build In New Protections