The Golden State (California) Tobacco Securitization 5.75% issue due in 2047 trades at around 69, for a yield of 8.5% (Cusip 38122NPA).
SATURDAY, JUNE 18, 2011 Smoking Out the Highest Muni Yields
By ANDREW BARY
Pimco's Bill Gross and other savvy fixed-income investors have loaded up on municipal bonds backed by tobacco-company payments to the states. The bonds yield about 8%.
While high-grade municipal bonds with 30-year maturities are yielding 4.5% to 5.5%, some tax-free bonds backed by domestic tobacco-company payments sport yields of more than 8%.
Indeed, the $40 billion of tobacco-settlement munis offer the highest yields of any major sector of the tax-free market. They have attracted big investors, including Bill Gross, manager of the $243 billion Pimco Total Return Fund (ticker: PTTRX), and muni-fund groups such as Oppenheimer Rochester seeking high yields.
Many states have issued tobacco munis, including California, New York, New Jersey, Ohio and Illinois. The bonds are backed by annual payments that will be made in perpetuity by domestic cigarette companies under the 1998 Master Settlement Agreement (MSA) reached with 46 states to resolve lawsuits filed by the states to recoup the cost of treating sick smokers. The four remaining states settled separately with Big Tobacco.
The table below shows specifics on three of the largest individual issues. The Golden State (California) Tobacco Securitization 5.75% issue due in 2047 trades at around 69, for a yield of 8.5% (Cusip 38122NPA). The Buckeye Ohio 5.875% issue due in 2047 (Cusip 118217AU) also fetches about 69, for a yield of 8.8%. The Tobacco Settlement (New Jersey) 5% due in 2041 (Cusip 888808DF) trades at about 64, for a yield of 8.25%.
States–and some local governments–mostly issued the debt to plug budget deficits. In so doing, they were able to obtain, in one lump sum, the present value of future MSA payments, rather than using future payments over many decades to treat sick smokers, as was intended.
The tobacco-muni sector carries more risk than most segments of the tax-free market, because these bonds typically are backed only by annual MSA payments and not by any state guarantee. The payment for 2010, which was made two months ago, totaled $6 billion. The bonds, originally sold with 5% to 6% yields, have fallen in price because MSA payments haven't met expectations.
The payments are pegged to U.S. cigarette consumption, which has fallen more rapidly than anticipated in recent years, due to increased national restrictions on smoking, as well as higher federal and state cigarette taxes. Consumption dropped by 9% in 2009, and another 6% last year, to 304 billion cigarettes (15 billion packs). That is well below the 441 billion sold in 1999. Many assumed 2% annual declines when the bonds were sold.
Major cigarette companies, such as Altria (MO), Reynolds American (RAI) and Lorillard (LO), have been able to offset volume declines with sharp price increases. MSA payments, however, reflect domestic cigarette-sales volume, not industry profits. The payments benefit from an inflation adjustment of at least 3% every year.
Standard & Poor's downgraded many tobacco bonds in November to junk status. Moody's gives most major deals tobacco deals investment-grade ratings, but barely, and might cut ratings to junk. S&P cited "revisions of the base-case and stress-case assumptions we used in the cash-flow-stress scenarios for these deals." S&P is worried that falling cigarette consumption could cut MSA payments, and imperil full payment of principal and interest on tobacco debt.
TOBACCO-MUNI BULLS say that the lofty yields compensate for the risk, especially as the average corporate junk bond yields 7%. An 8.5% yield on a Golden State issue is equivalent to a 13% fully taxable yield for a Californian in a 35% federal tax bracket. "You can't find any high-yield bond with a 13% yield" and the same credit quality of the tobacco munis, says one hedge-fund manager who owns the debt. There has been little new issuance in recent years. The major institutional dealers are Citigroup and Goldman Sachs.
Since there is no muni-bond exchange, individuals must buy bonds in an over-the-counter market, where price spreads can be wide. Potential buyers might want to check the http://investinginbonds.com Website for information on price history. Input the bond Cusip number for that history.
One quirky feature of tobacco munis is that issuers can't seek bankruptcy protection. Investors are entitled to each bond's earmarked MSA payments, whatever they turn out to be. Interest payments could come up short, and principal repayment might be delayed or not made in full. "The bonds are generally appropriately priced, given cigarette consumption projections. There may be a shortfall, depending on the bond's structure," says Tom Metzold, co-director of muni investments for Eaton Vance, which owns tobacco munis.
In its most recent semiannual report, managers of the Oppenheimer Rochester National Municipals Fund (ORNAX) wrote that "carefully researched MSA-backed bonds are fundamentally sound, and…will continue to provide high levels of tax-free income to the long-term benefit of our yield-seeking investors." The fund has 19% of its $5.6 billion in assets in tobacco munis, its largest sector-weighting. Pimco could be the biggest holder of such munis. The Total Return fund owns 25% of the Buckeye 5.875% issue.
Tobacco munis aren't for everyone, but many wealthy individuals could benefit from investing a small portion of their tax-free portfolios in these high-yielding securities.
Not a Match?
Tobacco-muni prices have fallen because payments from tobacco companies have slid as smoking has declined. But yields c
ompensate for the risks.
Tobacco Muni Issue Interest Rate Maturity Price* Yield Moody's/S&P
Buckeye Ohio 5.88% 2047 69 8.80% Baa3/BB-
Golden State (Calif.) 5.75 2047 69 8.50 Baa3/BB+
Tob. Settlement (N.J.) 5.00 2041 64 8.25 Baa3/BB-
*Face value is 100.
Sources: Bloomberg; Investinginbonds.com