Steady declines in smoking, a big win for public health, are creating problems for municipal bond investors.
A handful of bonds backed by yearly payments from tobacco companies under a landmark settlement with 46 states are in the earliest stages of default, and more distress is expected.
Dozens of states, counties and cities issued the bonds to receive billions of dollars upfront from the 1998 settlement. But now they are seeing smaller payments than expected from the companies as tobacco sales decline in America. There is also a renewed legal battle between the states and the tobacco companies, with the companies holding back nearly $8 billion in settlement payments, pending resolution.
So far, California, Ohio and Virginia, as well as Nassau County in New York, have resorted to tapping special tobacco-bond reserves to pay their bondholders, something analysts consider a technical default because it effectively means the bondholders are being paid with their own money.
One analysis of a sample of the roughly $55 billion in outstanding tobacco bonds foresees the potential for a handful of full-blown defaults more than a decade from now, but the continuing legal dispute could mean deeper problems sooner.
The prospect of eventual defaults among the hundreds of outstanding bonds underscores the risks inherent in forecasting tobacco payments decades down the road. In the rush to market, many overlooked a basic conflict: the states were banking on a certain level of payouts, even as they adopted antismoking measures that would reduce those amounts. As a result, the historically safe municipal bond market has been peppered with something unusual, a type of muni that actually defaults.
“This whole thing really smells,” said Richard Lehmann, publisher of the newsletter Distressed Debt Securities.
He said the worst case would be one or more of the states losing their tobacco payments entirely. The payments were supposed to run in perpetuity.
While some municipal bonds legally bind their issuing governments to raise taxes if that is what it takes to make good, tobacco bonds are typically issued by public authorities, which have no taxing power. So the investors, not taxpayers, will lose if the bond reserves eventually run out.
Early projections forecast that the tobacco payments would decline over time by about 1.8 percent per year, on average, as sales of cigarettes in America slowed. The payments have instead fallen by about 4.1 percent per year, according to Richard Larkin, director of credit analysis at Herbert J. Sims & Company.
Many of the tobacco bonds have maturities of decades, and if smoking keeps declining at the current pace, some of the reserves set up as backstops will run dry, Mr. Larkin said. At that point, investors — including individuals, insurance companies and mutual funds — will be at a loss.
It is difficult to predict when and where this will happen because the tobacco bonds were structured with a bewildering array of maturities, prepayment schedules and other special features that made them easier to sell but hard for even determined analysts to evaluate and compare.
In Mr. Larkin’s analysis of tobacco bonds issued by seven states and New York City, he found that if tobacco payments continued to decline by 4 percent per year, full-blown defaults would begin in 2024, when Ohio would be about $350 million short on $1.1 billion of tobacco bonds maturing that year.
New Jersey, California, New York City and Virginia would be several billion dollars short on tobacco bonds maturing in the years after that, Mr. Larkin said. But three states in his sample — Rhode Island, Louisiana and Washington — would still have enough money to pay their tobacco bonds in full.
To calculate the income stream for the bonds, the states and other governments used an independent consulting firm’s projections of the tobacco payments over 40 years, which proved too distant for accurate predictions.
Both Mr. Larkin and Mr. Lehmann were skeptical of the projections and issued reports saying so in 2003.
“Those were all bogus,” Mr. Larkin said. “Yet the consultants used that report year after year.”
He said states and municipalities finally started using more conservative projections about a year ago. That was around the time that Moody’s Investors Service revised its ratings criteria for tobacco bonds. Then, in the fall, Moody’s upgraded some bonds — the ones with very short maturities — to Aaa status but downgraded others deep into junk territory.
“They realized over the years that the ratings were far too high, just like other structured finance,” said Matt Fabian, a managing director of Municipal Market Advisors.
Minnesota and Illinois recently issued new tobacco bonds based on the lower projections.
The slow erosion of the reserves is not the only risk; an even greater threat is the new legal battle between states and the tobacco companies, which “creates a Russian roulette risk to all tobacco bond issues,” Mr. Larkin said.
The fight this time is over the states’ treatment of the tobacco companies that never signed the 1998 settlement.
That year, the 46 states agreed to drop their claims against the major tobacco companies in exchange for yearly payments to help cover the cost of care for people harmed by smoke. The payments would run in perpetuity, with the first 25 years alone promising nearly $250 billion.
Dozens more companies eventually signed the pact, and the other four states reached their own settlements independently. But dozens more tobacco companies, including the China National Tobacco Corporation, China’s giant state-owned company, did not sign.
The states passed laws requiring the holdouts to put substantial sums into state-owned escrow accounts, but the companies have challenged those laws as unconstitutional. The tobacco companies that did settle contend that the states have given those that did not sign an improper market advantage, and they have been withholding part of the money they would otherwise be sending every year.
The disputed money, based on lost market share, now totals about $7.7 billion. The matter is in arbitration.
“It’s going to take a long time to resolve,” Mr. Fabian said, “and it’s totally opaque.”