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Q

I have been told that it is more likely the tobacco bonds will go into technical default than outright default. Since the payments go on for perpetuity, if revenue is insufficient to make interest payments (or principal repayment), then bonds maturing in 2040 might not be repaid until several years later, but they will eventually be repaid. Also, why aren’t states obligated to buy back some of the bonds? If revenue is less than they need to pay the interest, it means they issued too many bonds.

A

James A. Klotz responds:

When these bonds were issued, the payment schedule that secured them was based on projections of future domestic cigarette consumption at that time. There were also certain enforcement procedures put in place to protect the participating cigarette manufacturers from loss of market share to non-participating companies.

In the interim, cigarette shipments have fallen short of estimates and the major tobacco companies have disputed payments, alleging a loss of market share and the failure of the states to enforce the protective provisions called for by the Master Settlement Agreement (MSA). These are factors that may cause bond maturities to be extended as well as raise the specter of outright default. Many of these issues are already in technical default, having dipped into reserves to remain current on interest payments.

Some states issued certain tobacco securities with a pledge to appropriate funds to cover any shortfalls down the road. These are referred to as “state enhanced.”  The bonds that have been downgraded by Moody’s do not enjoy a state pledge and are dependent solely on the payments from the tobacco companies.