Tobacco bonds have garnered a great deal of press following a widespread S&P downgrade and more recently a dispute between the states and participating cigarette manufacturers regarding annual Master Settlement Agreement (MSA) payments.
Background
Under the MSA, signed in 1998, major cigarette producers agreed to pay, in perpetuity, an amount equaling more than $200 billion for tobacco-related health care costs. In return, the 46 states that were party to the settlement agreed not to sue the companies for these costs in the future.
Over the ensuing years, many of the states securitized the payments from the tobacco companies in the form of tax-free bonds, which were then offered to the public.
One of the factors that caused the recent S&P downgrade of many tobacco issues to “below investment grade” was the diverting of a portion of these payments away from the bonds into a “Disputed Payments Account.”
As stipulated in the MSA, these disputes are to be settled through arbitration and enable the tobacco companies to challenge the amount of their annual assessments. Under the agreement, if the companies can prove they lost market share to non-participating manufacturers due to the existence of the MSA itself, and that the member states have failed to rigorously enforce the MSA, a portion of the payments due each year may be rebated to the cigarette producers.
In arbitration, the tobacco companies have made a convincing case that their market share has diminished. However, the second test – adequate state enforcement against non-participating manufacturers – remains unresolved for each year dating back to 2003. Arbitration has been a slow and tedious process and there is now more than $7 billion sitting in the Disputed Payments Account, rather than supporting the outstanding tobacco bonds.
These interruptions in payments have called into question the credit quality of the bonds and have consequently had an adverse effect on their market value.
Smoke May Be Clearing
It has been reported that negotiators for the tobacco companies have reached a tentative agreement with the attorneys general representing the 46 states in the MSA.
The settlement would allow the manufacturers to retain a portion of the disputed funds. This accord would release more than $5 billion to the states. It would also revise the rules governing how states collect fees and taxes from the smaller companies that did not participate in the MSA.
The optimism emanating from these discussions has produced a substantial rally in the tobacco bond sector. High-yield institutional investors have been major participants in the rally as the resolution of this dispute removes much of the uncertainty surrounding future revenue streams. Predictability is an important component in any bond analysis.
Now that prices of tobacco bonds have moved significantly higher, we are suggesting to clients that this would be an opportune time to review their portfolios to determine if they are over- concentrated in tobacco bonds, considering many investors attracted by higher than market yields have flooded into this sector in recent years.
Having collected this unusually high rate of return over the years should help to mitigate the impact of any loss of income sustained by moving to higher quality, investment-grade rated bonds during these unsettled times.