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Q

With federal tobacco taxes increasing 62 cents per pack to help pay for the S-CHIP program (State Children’s Health Insurance Program), what is the outlook for tobacco bonds? Will this be the end of new issues coming into the market? And what about MSA (Master Settlement Agreement) payments on existing bonds? Thanks for your help. Your Web site is always informative.

A

James A. Klotz responds:

Addressing your last question first: S&P recently declined to change the ratings on Altria and Reynolds American, the two largest cigarette manufacturers. Both companies continue to exhibit strong earnings and are expected to continue to do so, despite the coming excise tax increase. Since they account for a substantial portion of the MSA payments, we do not anticipate a major impact on their ability to meet their MSA payment obligations.

As to the impact of the tax increase to $1.01 per pack, it is hard at this point to estimate how shipments of cigarettes will be affected overall. The payments due to the states under the MSA will be based on 2008 shipments. Those appear to have declined between 3.5% -4%, depending on inventory adjustments and are within the accepted target range envisioned at the time of issuance of the outstanding tobacco bond issues. Payments for calendar year 2009, payable in April 2010, will reflect a partial implementation of the tax. Its true impact won’t be known until April 2011, when MSA payments for the full year 2010 will be due.

We would anticipate, at least initially, some further reduction in shipments as a result of the tax increase but have no way to measure how much. We do know from history that sizeable excise tax increases have caused temporary spikes in shipment declines, which typically recover to more normal levels afterward. Some people anticipate a shift in market share to non-participating manufacturers as a result of the tax increase, but we would point out that those manufacturers will be equally affected, so price differences are unlikely to affect smoking preferences alone.

With the financial difficulties many states are going through, it is likely that new tobacco bond issues may still come to market from states that have yet to issue such bonds as a way to gain a quick cash infusion. Such issues may be delayed while the impact of the tax increase is assessed. New issues would likely be structured to anticipate revised assumptions of shipment projections. Some issues may have state guarantees as do similar issues from New York and California.

It is clear that this large tax increase will likely affect the tobacco sector, but it’s unknown how smokers’ behavior may change. For better or worse, people have continued to smoke through good times and bad, regardless of public health policy and the increasing cost of cigarettes. The MSA seeks to reimburse states for health costs they have incurred from past tobacco use and that revenue stream is likely to exist for years to come.