The rapid growth of electronic cigarette sales poses a rising but under-appreciated risk to holders of as much as $96 billion of bonds tied to payments tobacco companies make to U.S. states from a sweeping legal settlement in 1998.
Tobacco bonds were already forecast by many analysts to begin defaulting within the next 10 years. That's because Americans have given up smoking at a faster rate than estimated when most of the bonds were sold in the previous decade.
Cigarette consumption has dropped an annual average 3.4 percent since 2000 while many bonds were structured to withstand consumption declines of only 2 to 3 percent.
But as smokers swap traditional cigarettes for tobacco-free e-cigarettes and other vaping products, the smoking rate is declining even faster and analysts now predict some bonds could go into default before the end of this decade.
"If the decline goes to 6 or 7 percent, it will be very quick," said Tom Metzold, portfolio manager at Eaton Vance Investment Managers. "I think that the first ones are probably five years away," he said in reference to defaults.
While still a small part of the cigarette market, sales of e-cigarettes and vaporizers have already grown to be worth more than $2.2 billion from next to nothing four years ago. By some estimates, they will capture more than half the smoking market within a decade, and tobacco companies are already jockeying for leading positions as that change unfolds.
"We believe consumption of e-vapor will eclipse consumption of combustible cigs over the next decade as technology improves," wrote Bonnie Herzog, analyst at Wells Fargo, who has tracked the tobacco industry for years, in a recent report.
Last month, Reuters reported that Reynolds American and Lorillard, the second and third U.S. cigarette makers, were exploring a merger. Lorillard's leading blu e-cigarette brand, which has roughly 50 percent of the U.S. market, is seen as one of the appeals of the deal to Reynolds.
Under the Master Settlement Agreement, or MSA, struck 16 years ago between the biggest U.S. tobacco companies and 46 U.S. states, the companies make annual payments to the states using a complex formula tied to U.S. tobacco shipments. The accord ended years of litigation brought by the states, which had sought to recoup healthcare costs for treating ailments tied to smoking.
The states with the highest populations, such as California and New York, are owed the most. The majority of them arranged to get much of their money up front by selling bonds and pledging the annual payments to the bond holders.
The only problem is that as tobacco shipments decline, so do the payments. And sales of e-cigarettes, which now appear to be helping to accelerate the tobacco-consumption decline rate, are not counted as cigarette sales under the MSA.
The outlook for tobacco bonds is so dire that a forecast last month from Moody's Investors Service predicted 65 to 80 percent were headed toward default.
Already at risk
Tobacco bond analysts have blamed the decline in consumption of cigarettes on public smoking bans and new excise taxes, until now.
Last year, cigarette shipments dropped by 4.9 percent, the biggest decline since the government passed a federal excise tax in 2009, a drop some blame on the rising popularity of the industry's new tobacco-free alternatives, such as e-cigarettes.
"The only cause I can attribute it to is e-cigarettes," said Alan Schankel, managing director of Janney Capital Market's Fixed Income Strategy team. "I think they are having an impact."
In 2013, Americans purchased 13.3 billion packs of cigarettes and 400,000 equivalent packs of e-cigarettes, versus 14.1 billion packs of cigarettes and 200,000 equivalent e-cigarettes in 2012.
Wells Fargo Securities predicts the pace at which consumers switch from traditional cigarettes to e-vapor alternatives will surge in the coming years. It estimates that sales volumes for traditional cigarettes in the U.S. will decline by 68 percent over the next 10 years, while vapor cigarette sales will soar by more than 13-fold in the same period.
The shift in consumer preference and the non-inclusion of e-cigarettes in the MSA "creates an incentive for tobacco manufacturers to encourage their consumers to switch to vapor products," wrote Wells' Herzog.
For Eaton Vance's Metzold, the recent takeover buzz in the industry confirms to him that e-cigarettes are where the companies see their future, at least in the U.S market.
"Here's your catalyst," said Metzold, who sold all of his tobacco bonds more than a year ago. "Tobacco companies are buying the e-cigarette companies."
Lorillard acquired blu for $135 million in 2012, and also bought the U.K. e-cigarette brand SKYCIG for $49 million. Reynolds began distributing Vuse e-cigarettes in June and the No.1 U.S. tobacco company, Altria Group, is soon due to roll out its e-cig brand MarkTen nationally.
Not everyone's a believer
Still, not everyone is convinced about the e-cigarettes boom and the likelihood of early default on the bonds.
"E-cigarettes are not a real replacement. They are another tool for people to quit smoking, but they are not a substitute. To me, it's a fad," said Dick Larkin, senior vice president and director of Credit Analysis, himself a smoker. "E-cigarettes are a threat to the MSA, but I don't think they are a material threat."
And the bonds are enticing for some, largely because they're so cheap and offer juicy yields at a time when high rates of return in the fixed income market are relatively scarce.
Boston-based investment firm Loomis Sayles bought tobacco bonds several years ago when they were trading at deep discounts.
"I don't think you can say with 100 percent certainty that e-cigarettes will supplant normal cigarettes. How does anyone even know that?" said Steven Bocamazo, credit research manager and senior research analyst at Loomis Sayles. "They have a small market share and, while growing, it isn't the big threat that everyone is making it out to be."
Tobacco-settlement debt currently counts among the highest-yielding in the municipal bond market.
The Standard & Poor's Municipal Bond Tobacco Index sports an average yield to maturity of 6.24 percent for the $23.9 billion of bonds it tracks. By comparison, S&P's index for general obligation muni bonds has a yield of just 2.9 percent.
But, even with a rally underway this year - the S&P tobacco bond index is up more than 13 percent—most continue to trade at distressed levels, reflecting their perceived default risk. Moody's rates around 80 percent of all tobacco bonds at "B1"—which is four notches below investment grade—or lower.
"There are fund groups like ourselves, that said, 'We don't like what is going on here, we're getting out,'" said Metzold.
Some states soften the blow
The softening revenue flowing to the bonds from weakening consumption trends has prompted some states to step in to support the bonds.
Earlier this month, New Jersey announced it would draw $12.5 million from reserves as a result of "insufficient tobacco settlement revenues" in April. Ohio and Virginia made similar announcements in May.
To further bolster payments, some Democrats in Congress want to fold e-cigarettes into the MSA, arguing the payments gives states "a powerful tool to stop e-cigarette makers from targeting youth."
But many states haven't spent the $100 billion received so far in tobacco settlement money on its intended use – to cover healthcare costs generated by smoking. Only 14.6 percent of the funding generated by tobacco settlement and state taxes are spent on causes recommended by the Centers for Disease Control and Prevention, the Campaign for Tobacco-Free Kids found.
Instead, states like New Jersey, New York and New Mexico have used some of the money to prop up general fund revenues or to service debt, among other things, according to the public policy group, State Budget Solutions.
Among state policy makers, the rise of e-cigarettes has caught the eyes of some but has not yet registered widely as a concern.
Spokespersons for California's Department of Finance and New Jersey's Treasury Department said they were monitoring the growth of e-cigarettes and both agreed it was "premature" to forecast how the new product would affect future MSA payments.
Kurt Kauffman, debt manager for the State of Ohio, said the state hadn't "reached the point of concern yet." Ohio expects to tap up to $31.5 million from a reserve account to cover a tobacco bond payment this year. "It's something that we pay attention to and have an interest in following," said Kauffman.