In the Tobacco Deal, a Bond Is Born
A new bond will allow states to speed up the process of collecting on their $206 billion settlement with the nation's four largest tobacco companies.
In 1998, the four biggest American tobacco companies settled lawsuits with 46 states by pledging to pay the states about $206 billion over 25 years. But Wall Street has come up with a way for states and municipalities to get their hands on more of the money immediately.
The solution is a tobacco settlement bond, a kind of tax-exempt municipal bond backed entirely by revenue from the settlement. The bonds, which are beginning to catch on with individual investors, generally receive single-A investment-grade ratings from the major bond-rating agencies.
Because the bondholders receive payments from four tobacco companies, the creditworthiness of the investment depends in large part, on the ability of these companies to keep selling cigarettes for another generation. The main companies behind the bonds are Philip Morris; R. J. Reynolds; Brown & Williamson, a division of British American Tobacco; and Lorillard, a division of the Loews Corporation. Revenues from 17 other companies are also providing part of the settlement payments.
"It's a much different bond from one in which school taxes pay off the bondholders," said David Baldt, managing director of Deutsche Asset Management. "Most people who get these won't know what they are."
Investors in traditional municipal bonds are paid from tax revenue, a diverse base that can be increased by governments if shortfalls arise. Tobacco settlement bonds are backed by a single source of revenue the payments from the tobacco companies. Special-purpose corporations, set up to issue the bonds, take in the payments and pay the bondholders. The bonds are tax-exempt because the proceeds are used for public purposes, said John J. Hallacy, managing director in charge of municipal bond research at Merrill Lynch.
The first bond issue, a $709 million offering, was sold by a special-purpose corporation set up by New York City in November 1999. Since then, more than $4.4 billion in tobacco settlement bonds have been sold by states including South Carolina, Alaska and Alabama as well as cities and counties including Westchester and Nassau Counties in New York. Major offerings are expected by the end of the year from Louisiana and San Diego County in California.
For state and local governments, the bonds offer more than immediate cash. They also transfer to bondholders the risk of not being paid, according to Fitch, a bond rating service.
In assessing this risk, the rating agencies analyze the financial condition of each of the tobacco companies. That means looking at how much cigarette consumption is likely to change, the risk of continuing litigation against the tobacco companies and the possibility that any would file for bankruptcy, said Bernhard Fischer, a director at Standard & Poor's, which rates bonds.
In light of these risks, Mr. Fischer said, "there won't be a triple-A tobacco deal." Triple A is the top investment grade rating, meaning that the issuer has an "extremely strong" likelihood of repaying bondholders.
To achieve a single-A rating, which means that the issuer has a "strong" ability to fulfill its obligation, the offerings were structured with protections that capture payments not immediately needed to pay interest and principal. This money can be used to pay bondholders in the event of trouble, reducing long-term risk, according to S.& P.
With the stock market in the doldrums and interest rates falling, the steady tax- free payments provided by these bonds have gained popularity among individual investors. In early August, they bought more than half of a $127 million offering by the Northern Tobacco Securitization Corporation, a special-purpose corporation established by Alaska, according to Bear, Stearns, the lead underwriter. In the last six months, investors have become more comfortable with the bonds' risk and structure, said Daniel Keating, senior managing director for municipal bonds at Bear, Stearns.
Yields on tobacco settlement bonds have fallen as prices have risen. For instance, the 30-year 6.375 percent term bonds in South Carolina's $934 million deal were priced to yield 1.35 percentage points more than the benchmark yield of top-rated municipal bonds of 6.48 percent; in the middle of August, the same bond traded at a yield of only 5.75 percent, 0.74 percentage pointsmore than the benchmark, according to Bear, Stearns.
"It's not a question of who buys it anymore; it's a question of who doesn't buy it," Mr. Keating said.
Municipals in general are particularly appealing these days because they now yield more, on an after-tax basis, than Treasury bonds. Money managers like Jeffrey Slater, chief investment officer at MMA Investments, an investment firm specializing in municipal bonds, have found it difficult to find bonds to buy. "There's a lot of money chasing few bonds," said Mr. Slater, who does not own any tobacco bonds.
In addition, tobacco bonds still carry comparatively high yields: the Alaska offering included a 28-year 5.5 percent term bond that was priced to yield 5.62 percent, or 0.57 percentage points more than the benchmark yield of top-rated municipal bonds, according to Bear, Stearns.
That 5.62 percent yield would translate to an after-tax yield of 7.80 percent for an investor in the 28 percent tax bracket. A 30- year Treasury bond was yielding 5.83 percent at the time.
Still, some investors are not willing to risk buying bonds that essentially depend on people continuing to smoke.
"If you are a nonsmoker and you don't like smoking and you aspire for a smoke- free environment, why would you put your money in something that depends on increasing cigarette consumption?" said Robert Rikoon, a financial adviser in Santa Fe, N.M.
Mr. Slater of MMA Investments said, "If there are investors who invest in muni bonds for socially responsible reasons, I don't know if tobacco bonds really work for them."
The state attorneys general who negotiated the settlement had intended the money to pay for smoking prevention and for the health care costs of smoking. But as little as 5 percent of the money is going to prevent and stop smoking, according to a recent report by the National Conference of State Legislatures. "I didn't battle against an invincible industry so folks can make money on Wall Street," said Michael C. Moore, the Mississippi attorney general.
To some institutional buyers, tobacco bonds are simply a good deal. Lyle Fitterer, a portfolio manager at Strong Capital Management, said the fundamentals of tobacco companies had improved, as reflected in the stock prices of R. J. Reynolds and Philip Morris. Tobacco settlement bonds also yield more after taxes than comparable corporate bonds issued by the tobacco companies, Mr. Fitterer added.
If demand for the settlement bonds pushes prices higher, resulting in lower yields, or if the fundamentals of the tobacco companies weaken, Mr. Fitterer said he would be inclined to sell some of the bonds.
"We would be able to lighten up fairly quickly," he said.
Mr. Rikoon said individual investors might not be able to reduce their holdings as nimbly. Such investors generally buy bonds in odd lots, which is anything under $100,000. Typically, they pay a commission of as much as 2 percent of the principal amount each time they trade.
"The more esoteric a bond, and the weirder the size, they are going to be at a disadvantage when selling the bond," Mr. Rikoon said.