April 15th is always a special date for us muni geeks, particularly those of us who are focused on the high yield tax-exempt market. Aside from serving as a reminder of the value of tax-exempt income, Tax Day is also the day tobacco companies make their annual Master Settlement Agreement (MSA) payments. Yesterday, Altria’s Philip Morris reportedly paid $3.3 billion as their share of this year’s MSA collections.
Since we last wrote about tobacco bonds, just about a year ago, the threat to traditional cigarette sales from alternative delivery devices such as e-cigarettes has gone from “potential” to “very real.” This matters greatly to tobacco bondholders, of course, because these devices are not included in the MSA and may further accelerate the ongoing decline in cigarette sales. Bonnie Herzog, a long-time sector expert at Wells Fargo, now projects that by 2023, e-cigarette sales will overtake traditional tobacco revenues at all three of the major tobacco companies: Altria, Reynolds and Lorillard. Conventional tobacco revenues, for their part, are forecast to decline by a stunning 50% by 2023.
[In the past year], the threat to traditional cigarette sales from alternative delivery devices such as e-cigarettes has gone from “potential” to “very real.”
In all fairness, last year may yet prove to be the peak market penetration year for e-cigarettes. Between public endorsements from “cool” movie stars, the ability to advertise, a shortage of research on their potential health effects and a virtual lack of regulation, e-cigarettes should have had a banner year, and, in fact, they did. The high school and college crowd in particular has proven to be a very receptive audience for “vaping.” No wonder Big Tobacco now regards e-cigarettes as their ultimate salvation and is moving aggressively into that market.
In fact, e-cigarettes themselves may soon be displaced by other more specialized devices with such names as “vapors,” “tanks” and “mods”. This fact was driven home to me at a recent industry conference in Ft Lauderdale, Florida, when I kept seeing a “hookah” truck go up and down the city’s beachfront.
Not surprisingly, a backlash of sorts is already brewing. Certainly, the issue of whether or not “vaping” does help smokers quit or may in fact be another gateway to smoking cannot be resolved until more conclusive research evidence emerges. The FDA is under pressure to start regulating this industry. In any case, the apparent success of e-cigarettes appears to have re-galvanized anti-smoking sentiment and that, in itself, does not bode well for tobacco bonds.
Since their very inception, tobacco bonds have been a boon to active traders, since volatility has become the hallmark of the sector. Consider this: among all high yield sectors included in Barclay’s high yield muni index, Tobacco was the top performer in 2011 and 2012, with annual returns of 23.0% and 32.4% respectively, but dropped to second-worst in 2013 with an 11.6% loss in 2013. Riding on the muni market’s rebound in the first quarter of this year, tobacco bonds have already risen 11.1% through March 31, recouping all of last year’s losses in only three months.
Since their very inception, tobacco bonds have been a boon to active traders, since volatility has become the hallmark of the sector.
The sector’s credit spreads have exhibited the same degree of extreme volatility. The yield difference between the S&P Municipal Bond Tobacco Index and the S&P National AMT-Free Municipal Bond Index started the year 2012 at 420 basis points, got as tight as 108 basis points by mid-February 2013 and, in response to the bond market selloff last year, blew out to 409 basis points again by February of this year. Since then, spreads appear to have stabilized in the 380-390 range. Obviously, volatility is great only if one can stay on the right side of these violent moves!
Before Puerto Rico became the mother of all distressed trades, tobacco bonds were a favorite target for crossover investors. Many hedge funds are well-versed in asset securitization financings and can easily wrap their arms around cash flow instruments such as tobacco bonds. They can model it out, devise some fancy hedges (perhaps involving the tobacco companies’ own securities) and trade the volatility. In the process, they’ve also provided significant liquidity to the sector: large tobacco issues such as Ohio’s Buckeyes regularly show up among the most actively traded bonds in the market.
Unlike tobacco bonds, traditional munis such as Puerto Rico lie outside the hedge funds’ normal comfort zone and it shows: the PR G.O. 8.00% of 2035 from the recent, much-ballyhooed $3.5 billion issue has traded down almost 7 points from the original issue price.
Given the very real possibility of default on many of the tobacco issues over the next 20 years, we find it surprising that many muni investors still trade them in the traditional manner, i.e. on a yield-to-worst basis. The preferred approach, at least in our view, would be to model each issue’s future cash flows to maturity, with cigarette consumption rates as a key variable, and then decide if the current market price provides you with an acceptable internal rate of return based on various potential default scenarios. Alternatively, you could also back into a price you’re willing to pay for the bonds based on your preferred default scenario. Having said that, we suspect very few muni buyers have devoted their resources to build internal tobacco bond cash flow models, putting them at something at a disadvantage versus many of the larger broker-dealer firms who have, in fact, made that analytical investment.
With the proper research, tobacco bonds can be attractive trading opportunities. As a tool for politicians to raise some quick cash to plug budget holes, they are unequalled.
As part of the Detroit bankruptcy negotiations, the State of Michigan has suggested it could contribute up to $350 million to help the City’s pensioners by securitizing another portion of its tobacco settlement receipts.
The most egregious use (or abuse) of tobacco settlement receipts for short-term fiscal expediency purposes was perpetrated by the State of New Jersey just a few weeks ago, as reported by veteran analyst Dick Larkin from H J Sims. Apparently, the Garden State cut a deal with some of its tobacco bondholders to significantly enhance their security, in exchange for about $92 million in upfront cash that it intends to use toward this year’s budget deficit.
Here’s the rub: the bonds in question, the Series 2007-1B and 2007-1C subordinated zero coupon bonds, were already heading for default based on current tobacco consumption rates. The settlement with the State basically bailed them out, resulting in a significant windfall for bondholders. New Jersey gave up about $50-60 million in annual settlement payments from 2017 through 2024 (totaling around $400 million), just to get its hands on $96 million of upfront cash.
While we applaud the bondholders for exploiting the State’s fiscal short-sightedness to their advantage, (with a little help from Barclays), New Jersey fiscal watchdogs should be up in arms about this latest budget maneuver.
According to the Wall Street Journal, “about 76% of the tobacco revenues New Jersey collected every year were going toward paying off the bonds, with the rest going to the state’s general fund. But with the recent agreement with investors, New Jersey is pledging the remaining 26% of its tobacco revenues to pay off the zero-coupon bonds early. Assuming a cigarette-shipment decline rate of 5%, the state will pay these bondholders about $400 million between 2017 and 2024, according to public documents.”
As usual, we can count on our old friend Dick Larkin from H J Sims, a long-time observer of New Jersey state finances, to put everything in the proper historical context: “This complicated transaction to raise a paltry $96 million ranks with some of the worst gimmicks that used long-term bond funds to pay for annual expenses. These include the sale of an existing road to the NJ Turnpike for $400 million under Governor Florio, and the abuse of a pension funding bond issue to provide two years of bond money to pay annual bills under Governor Whitman.”
What’s worse, the State didn’t fool the rating agencies for even one minute with this fiscal gimmickry. The use of this one-time budget measure, along with many others, was one of the factors behind Standard & Poor’s recent downgrade of New Jersey G.O.s, from AA- to A+. According to S&P, “total use of non-recurring measures range from $1.8 billion to $2.07 billion, or between 5.5% and 6.3% of the budget, depending on whether these additional shortfalls materialize.”
Tobacco companies and public officials do make strange bedfellows. But, in spite of all the anti-smoking rhetoric, state and local officials are more dependent than ever on tobacco settlement monies and sin taxes (just ask Chicago). One trick they’ve mastered, with the help of Wall Street, is to shift the long-term collection risk onto the municipal bond market through securitization. Let’s hope the buy side’s risk management practices (if any) will be equipped to handle an unforeseen shock to this $97 billion sector.
Note: Believe it or not, this issue marks the first anniversary of Muni Bond Insights. When I was approached by MuniNetGuide.com a year ago to produce a weekly municipal market commentary column, I wasn’t quite sure what it would develop into, in all honesty. All we recognized was a need for an independent voice in the tax-exempt market, away from the standard broker-dealer published research (or whatever is left of it) and the occasional commentary pieces from the mutual funds, with their obvious (and understandable) biases. Based on your overwhelming response to date, it seems we’ve been able to fill an information void out there. In fact, the most positive feedback we’ve received has been from the younger generation of muni professionals and from investors who are relative newcomers to the tax-exempt market. To the extent we’ve been able to act as your guide to the intricacies of the tax-exempt market, we feel like we’ve accomplished something. We do want to thank MuniNetGuide.com for providing us with this valuable and timely forum, and most of all, our faithful readers for their support.
See you all next week.
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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