Municipal Bond Forum

Home > Municipal Bond Forum > Tobacco > Impact of tobacco shipments on bonds

Q

An article last year in the Journal of Structured Finance analyzes cigarette consumption and the potential impact it could have on tobacco muni bonds. It shows that long-term smoking is likely in more of a decline than tobacco settlement revenue data indicates, which could seriously impact the muni bonds’ ability to pay. What is your opinion?

A

James A. Klotz responds:

I wish I could definitively project the decline in tobacco shipments in the future, but doing so would be difficult, at best. Each issue of tobacco settlement bonds was structured based on smoking and shipment projections made by Global Insights, a world-renowned economic consulting organization. Bond maturity schedules were structured to provide estimated ample debt service coverage for a “base” (expected) case, and one or more “low” cases in which cigarette shipments would be lower than anticipated.

The projections made by Global Insights took into account a 50-year known history of cigarette usage and incorporated historic rates of smoking decrease as well as projections assuming an acceleration of historic rates. Since the advent of the Tobacco Settlement in 1998, numerous state and federal excise tax increases have taken place, class-action court cases have been filed and mostly resolved, and tobacco companies have merged. Tobacco bond issues have seen their initial ratings downgraded by the rating agencies as their internal models have become more conservative. Yet, the tobacco bonds have continued to pay on time.

The problem with projecting future cigarette shipments is that we really have no way to predict human behavior when it comes to smoking. We do know there is a downward trend that has been existent since long before the tobacco settlement took effect. We also know that major rises in tobacco excise taxes have resulted in “bumps” in the rate of shipment declines for a year or so, before the rates of decline have returned to more traditional rates.

Reporting of tobacco shipment data has been spotty at best. The major tobacco companies, which are part of the settlement, but not party to the bond issues, have provided little data publicly in order to protect their proprietary business positions. States report shipment data separately and often with long time lags. The federal government also provides severely lagging data that requires refinement over time as tax stamp and other information trickles in.

All of this is to say that the current basis for future projections is unreliable. Despite several respectable studies by my industry peers projecting a sharp decrease in tobacco shipments over the medium – long term, the data just isn’t reliable enough to reach such conclusions, in my estimation.

An article last month in The Wall Street Journal, titled “Downward Trend in Smoking Rate Stalls,” reported that federal health officials found a slight increase in the smoking rate last year, a clear change from recent history. Is this unexpected finding an indication of a major change in consumer smoking behavior? An aberration? No one knows.

What we do know is that over the last 10 years, cigarette consumption has declined at a rate close to the upper end of the band of projected decrease. Beyond that, predicting the future with a high degree of certainty is impossible given the volatility of the data.