Although Tax Day and the Boston Marathon will now and forever be remembered for last week’s tragic events, the week of April 15th also holds a special meaning for holders of tobacco bonds backed by the so-called Master Settlement Agreement (MSA) between the big tobacco companies and most of the states.

This is because every year, on April 15th, the Big Three tobacco companies (Altria, Reynolds and Lorillard) make their annual MSA settlement payments for the preceding year. By April 19th, the smaller tobacco manufacturers that subsequently joined the MSA will also have made their contributions. So every year, around tax time, tobacco bondholders hold their collective breath until the settlement money actually shows up.

This year, according to a recent report by the well-respected Dick Larkin from H.J. Sims, things have gotten a bit more complicated due to the December 2012 resolution of the Non-Participating Manufacturers (NPM) dispute. One may recall that, as part of the original agreement, the states are required to do their best to protect the participating tobacco companies from losing market share as a result of their participation in the MSA. More specifically, states must enforce statutes requiring tobacco companies that did not sign the MSA – the NPMs – to make payments into escrow accounts that would be tapped to defray the costs of future smoking-related litigation. The real intent, of course, is to ensure a level competitive playing field between the participating and non-participating manufacturers.

… every year, around tax time, tobacco bondholders hold their collective breath until the settlement money actually shows up.

As it turned out, over the last nine years, the Big Three have been unhappy about the states’ lackadaisical enforcement of the NPM statutes and, as a result, have been depositing a portion of their annual payments into an escrow account under protest. By the end of 2012, almost $4 Billion had been set aside in such escrow account.

On December 18, 2012, the Big Three announced a settlement of the NPM dispute with 19 of the states and other jurisdictions, including the District of Columbia and Puerto Rico (Shockingly, both sides claimed victory). The 19 settling entities accounted for 42% of the $4 Billion in escrow, so they stood to receive their pro rata share of about $1.7 billion last week. The Big Three also came away with $1.6 billion in refunds, to be spread over the next five years.

Due to all the partially offsetting payments, it will take us a while to figure out the net result of the 2012 settlement on the respective tobacco bond series’ cash flows. As far as we can tell, there will be a short-term windfall to the settling states this year but such windfall will be reduced over the next five years by the refund requirement. The refunds may be reduced should more states join the settlement agreement this year. State tobacco programs that have already gone into technical default, such as California and Virginia, will see improved cash flows this year but such relief will be likely short-lived.

By sheer coincidence, the Big Three are also reporting their first quarter earnings this week. According to the Wall Street Journal, all these earning reports will share a common theme: “Cigarette volumes will fall, but profits will rise.” Up until now, tobacco manufacturers have been quite successful in raising prices and passing along any tax increase, even in the face of annual declines in consumption of 3-4% annually. This past quarter saw even more dramatic volume drops, ostensibly as a result of “higher energy prices, expiration of the payroll tax holiday and fewer shipping days”. For instance, domestic cigarette shipments at Reynolds fell sharply by 5.6%, even after adjusting for fewer shipping days. Yet the company’s adjusted earnings still rose 14%.

As far as we can tell, there will be a short-term windfall to the settling states this year but such windfall will be reduced over the next five years by the refund requirement.

Unfortunately, MSA payments are driven purely by shipment volume, not by the tobacco companies’ profitability. While tobacco bonds’ cash flow projections already assume a 3-4% decline in shipments, a more significant and sustained downward trend would not be a welcome development.

Other dark clouds loom over the horizon: the Obama Administration is proposing a 94% federal excise tax increase as part of its 2014 budget. The State of California is reportedly contemplating a new $2 per pack tax levy. New York City is looking to raise the legal age for cigarette smoking from 18 to 21. Mitch Zeller, the new head of the FDA’s Center for Tobacco Products, is promising increased regulatory vigilance. All in all, a new anti-smoking fervor seems to be gripping the land, driven in part by politicians’ search for new sources of revenue.

Current and potential investors should also keep these other long-term considerations in mind: (1) new product areas such as smokeless tobacco and e-cigarettes are excluded from the MSA; and (2) only the domestic units of the tobacco companies are a party to the MSA, yet much of the recent growth in volume has occurred in foreign markets.

As a pure income play, the tobacco bond sector has indeed been irresistible, with yield levels in excess of 7.00% for much of the last year. However, the recent yield chase has brought tobacco spreads down to around +300 basis points (bp) off AAA. The New Jersey Tobacco Settlement Financing Corp. 5.00% due 6/1/41, B2/B- rated recently traded at +292 bp to maturity. Puerto Rico Aqueduct & Sewer bonds 6.00% due 7/1/44, still rated Ba1/BB+, also traded at +282 bp. One might wonder which issue is the better relative value at this time?

At the end of the day, one would do well to remember the very reason tobacco bonds are issued in the first place: to give the respective state and local entity all the cash up-front and to shift all the economic risk over to the bondholders.

Now if only we could renegotiate the MSA to include the fast-growing medical marijuana sector, tobacco bondholders may be able to sleep a little easier.

Disclaimer: The opinions and statements expressed in this column are solely those of the author and Axios Advisors, who are solely responsible for the accuracy and completeness of this column. This column does not reflect the position or views of RICIC, LLC or MuniNetGuide.

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