You have not saved any content. Explore our site now and save your favorite products, insights, and/or documents.
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.
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.
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.
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.
Our central hub for Muni content and investments
Head of Municipal Bond Portfolio Management
Heightened market volatility has led to misconceptions about credit, in our view. We dispel four of them here.
In the absence of immediate and substantive policy easing at the national level, we believe that the sector could pose a serious risk to the government’s GDP growth target in 2022.
Federal Reserve hikes policy rate 50 basis points, while remaining flexible in fighting inflation.
We assess risks and potential opportunities for multi-asset portfolios amid late-cycle dynamics, higher inflation, rising interest rates, and geopolitical uncertainty.
Hotels have recovered from the depths of the pandemic, but markets continue to evolve and the recovery has been uneven.
The Bank of Canada embarked on a swift tightening path, but secular forces still weigh on the longer-run interest rate outlook.
We believe the municipal markets should remain strong into 2022, although the good news may already be baked into high quality bond valuations.
Supply chains set to become less dependent on China over time.
All investments contain risk and may lose value. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. There is no guarantee that these investment strategies will work under all market conditions or are suitable for all investors and each investor should evaluate their ability to invest long-term, especially during periods of downturn in the market. Investors should consult their investment professional prior to making an investment decision.
Hypothetical and simulated examples have many inherent limitations and are generally prepared with the benefit of hindsight. There are frequently sharp differences between simulated results and the actual results. There are numerous factors related to the markets in general or the implementation of any specific investment strategy, which cannot be fully accounted for in the preparation of simulated results and all of which can adversely affect actual results. No guarantee is being made that the stated results will be achieved.
This material contains the opinions of the author but not necessarily those of PIMCO and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. No part of this material may be reproduced in any form, or referred to in any other publication, without express written permission. PIMCO and YOUR GLOBAL INVESTMENT AUTHORITY are trademarks or registered trademarks of Allianz Asset Management of America L.P. and Pacific Investment Management Company LLC, respectively, in the United States and throughout the world. ©2015, PIMCO.