This article originally appeared in a modified form on Institutional Investor.
Municipal tobacco settlement bonds are one of the largest, most liquid and highest yielding sectors within the municipal high yield bond market. Issued by 17 states, the District of Columbia, three territories and a handful of counties, senior lien tobacco bonds total about $32 billion in par amount outstanding, with $19 billion rated below investment grade. They have a unique, securitized structure that is sensitive to future cigarette consumption, requiring detailed modeling and forecasting to support investment decisions. Despite the headline risks regarding cigarette consumption declines, we see many tobacco bonds as an attractive source of yield given their risk profile.
How they work
Municipal tobacco bonds are secured by a claim on a perpetual stream of annual settlement payments owed from the U.S. tobacco manufacturers to the states. These payments result from the 1998 Master Settlement Agreement (MSA), the landmark court settlement between the then-four-largest tobacco companies and 52 Attorneys General. Under the terms of the settlement, the tobacco companies agreed to make annual payments to the states and to restrict many of their advertising practices, particularly those targeting young consumers. In return, the participating states and territories released the tobacco companies from past and future liabilities arising from tobacco-related health care costs. The MSA payments were set at approximately $9 billion per year across all 46 participating states, subject to annual adjustments for U.S. cigarette consumption, inflation and other variables. A number of states have since securitized their share of the MSA payment, thus creating this municipal bond sector.
Tobacco bonds frequently make headlines given the sensitivity of the MSA payment to the secular decline in tobacco consumption. Many of the bonds issued in the mid/late 2000s were structured with high leverage, requiring annual cigarette consumption declines of less than 4% per year to fully repay. Since then, actual cigarette consumption has come in lower than those expectations, declining an average of 4.5% per year starting in 2006. While good for society and public health, this has led to ratings agency downgrades and increased uncertainty of full repayment. According to our estimates, a large portion of these bonds can now only withstand around 3% to 3.5% per year in cigarette consumption declines for full repayment of principal at stated maturity.
The most important factor affecting the stream of settlement payments under the MSA is U.S. cigarette consumption. A quick look back in history: Cigarette production began in the U.S. in the early 20th century. In 1964, the U.S. Surgeon General released a report titled “Smoking and Health” that warned of smoking’s adverse health effects. In 1981, the number of cigarettes smoked annually in the U.S. peaked at 640 billion. This number has since fallen to 263 billion for 2014 as usage bans, cigarette taxes and other restrictions have been enacted.
Forecasting future cigarette consumption is not an easy task; a good starting point is to look at the historical average of consumption declines. While the consumption decline has averaged 2.8% per year between 1985 and 2014, declines have accelerated over time with 1985-1995 averaging 1.8% per year, 1995-2005 averaging 2.5% per year and 2005-2014 averaging 4.0% per year (see Figure 1).
Looking at the various historical drivers of U.S. cigarette consumption, PIMCO has found that the size of the U.S. adult smoking population, the price of cigarettes (including increased taxes), changes in disposable income and certain other factors have all had significant effects on cigarette smoking. These pressures have increased over time, culminating in the 2009 decline of 9.35% that coincided with a 62 cent-per-pack federal excise tax increase and the Great Recession.
We forecast cigarette consumption declines will exceed the historical average, and assume that many of the pressures (e.g., smoking population decline, taxes) seen in the past 10 years will continue. Our forecast also gives credit to human ingenuity in finding new ways for people to quit, and factors in negative network effects that tend to cause the pressures against smoking to grow (e.g., social stigma, taxes, regulation) as fewer people smoke. Over the past decade, advances in pharmaceuticals and in alternatives such as e-cigarettes have contributed to declines.
As mentioned earlier, many tobacco bonds require 3% to 3.5% average annual consumption declines to fully repay, and therefore they would likely default under our forecasts.
Wait, did you say default?
Yes; however, municipal tobacco bonds can still be an attractive investment. This is because they behave differently from a typical corporate bond in a default scenario. For a typical corporate, assets are sold or debtor liabilities are reorganized, leaving the original creditor with a recovery claim. For a tobacco bond, if the tobacco trust does not have enough cash to pay interest and principal due, bonds remain outstanding (no acceleration) and payments continue to be made from whatever tobacco settlement revenues are available. As a reminder, the settlement payments go on in perpetuity until the bonds are paid off or people stop smoking altogether.
While bondholders may not receive 100% of promised cash flows in a default scenario, our projections show they may receive a substantial enough sum to generate moderately attractive internal rates of return based on today’s prices. To see how this could be possible, Figure 2 displays a list of hypothetical 30-year bonds with different coupons priced at par. The middle column displays the internal rate of return if the bond pays interest for 30 years but then defaults on principal. The higher the coupon, the larger the percentage of one’s yield to maturity comes from receiving the coupons as opposed to the principal.
While tobacco bonds are more complex than this example, long maturity 2007 vintage tobacco bonds have a current yield (coupon/price) in the 6%-7% range, indicating that a large part of their promised yield to maturity comes from the coupon payments. We believe full interest payment is highly likely over the next decade, as this is before large term bond maturities come due and the trust may still draw from a reserve sized at roughly one year of debt service. After default, tobacco settlement payments are divided pro rata among bonds first to pay interest, with any excess used to pay down principal. A 1% decline in settlement revenues each year is still enough in most cases to generate internal rates of return (IRRs) within 2% of the stated yield to maturity, despite full principal not being repaid.
Downside protection Municipal tobacco bonds offer relatively good cash flow returns even in downside scenarios where smoking declines are larger than expected. While there are left-tail risks to cigarette consumption, broadly speaking the MSA cash flow is relatively stable. Even under a 6%-per-year consumption decline scenario, which is 50% higher than the average consumption decline over the past decade, bond cash flows decline by around 3% per year or less given the inflation adjustment. It would take a very severe cigarette consumption decline for the cash flow IRR to turn negative, providing investors with some cushion. To illustrate, Figure 3 shows the average IRR of a handful of longer benchmark tobacco bonds under a variety of consumption decline scenarios. Forecasted IRR, while much lower than the bond yield to maturity, is still positive even in relatively steep consumption decline scenarios.
As we do with all other investments, PIMCO forecasts expected cash flows under a variety of scenarios, gauges the risk associated with those cash flows and applies an appropriate discount rate to determine whether the market price of the asset is attractive. There are many different tobacco bonds, each with their own repayment schedule and likelihood of loss. PIMCO models each of these bonds and chooses to invest in those that offer the best forecasted spread return relative to the bond’s ability to avoid credit loss. With careful security selection and credit modeling, we believe active management can add a great deal of value in optimizing tobacco exposure.
To learn more about investing in municipals at PIMCO, please visit pimco.com/munis.