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Q

In reviewing the recent financial statements for some of the tobacco bonds that I hold, it appears that tobacco revenues pursuant to the Master Settlement Agreement are declining as a result of declining tobacco sales in the United States and, in some cases, the revenues are even less than the expenses. What is your outlook for tobacco bonds?

A

James A. Klotz responds:

As you have observed, prices of tobacco settlement bonds have been under pressure recently due to declining cigarette sales and disputed amounts by the tobacco companies regarding how much their contributions should be.

The dispute hinges on whether some of the tobacco companies, Phillip Morris included, have lost significant market share to non-participating producers which, according to the Master Settlement Agreement, would reduce their required payments.

Because of the dispute, the participating tobacco companies placed a portion of their payments in escrow pending an arbitration ruling. This escrowing of funds, rather than actually making the payments, has led to a decline in revenues to the states in support of these bonds.

If the tobacco companies are victorious in this legal action, it will likely put further pressure on tobacco bonds as the states will be forced to attempt to recover these shortfalls from the non-participating vendors.

Although our analysts expect the decline in cigarette consumption to taper off over the next few years, the fact that state laws are reducing the places where smoking is permitted, will continue to cloud the future of these securities.

The higher yields available on tobacco bonds today are a concession to the uncertainty and potential risk going forward.