Bondholders Likely to Suffer From States’ Tobacco-Funding Addiction

It was an offer difficult for many cash-strapped states to pass up. Take billions of dollars upfront from a 1998 settlement that attorneys general in 46 states inked with four major tobacco companies and pass the risks onto investors.

Since the early 2000s, 19 states, the District of Columbia and three territories have used their share of a $200 billion tobacco settlement due to be paid out over 25 years to serve as collateral on about $55 billion of mostly tax-exempt municipal bonds.

Illinois, which had been taking in about $300 million per year from this settlement, issued $1.5 billion in bonds backed by its share of the proceeds in December 2010. That’s a useful amount as Illinois desperately searches state coffers for revenue to close its budget gaps.

As I spell out in an article in the April 25, 2011 issue of Forbes Magazine, investors in these tobacco-settlement securities may now be holding bonds at risk of default. As Americans kick the smoking habit, investors in these securities may take the hit as dwindling cigarette sales cause payments to fall off a cliff.

Most tobacco bonds have a so-called turbo structure (rather like a sinking fund). For the issuer it works like a prepayment option does for a mortgage borrower. For years that meant states used the settlement cash they received in excess of what they needed to make interest payments to pay down principal. Prices factored in expectations that outstanding values would decline and the bonds’ weighted average lifetimes would fall short of their official maturity dates.

Investment banks like Citigroup who structured more than half of these deals, Bear Stearns, UBS, Merrill Lynch and Morgan Stanley, have taken in millions in fees. Since the bond issuances have been drafted as bankruptcy-remote, investors only have the payouts from tobacco companies as collateral.

The National Association of Attorneys General drafted the 1998 settlement that indemnified the big four cigarette manufacturers- Philip Morris USA, R.J. Reynolds Tobacco Company, Brown & Williamson Tobacco, and Lorillard Tobacco – so that these companies would pay states as a percentage of cigarette cases shipped in the US each year. As states and the federal government have passed laws making it more difficult to sell cigarettes by raising taxes and putting more restrictions on sales, cigarette companies actually payout less money from that settlement. In 2009, when volumes of cigarette cases shipped dropped 9.3% to 324 million, tobacco manufacturers paid $6.4 billion around tax time in 2010 compared to original projections around about $8.1 billion if cigarette smoking had decreased less rapidly (about 3% per year).

The National Association of Attorneys General told me that they’ll release the payment amount cigarette companies will make around April 22, 2011,after its been paid. Bondholders will then have a better sense of how much money will be used to pay down their principal with the turbo structure. According to data from the Alcohol and Tobacco Tax and Trade Bureau, cigarette shipments declined 4.5% in 2010.

The market has been relatively quiet for new issuances, since 2007. Illinois’ $1.5 billion December 2010 was among the first. Analysts and bankers in the industry say that despite state budget turmoil, they don’t expect many new issuances this year.