Tobacco Bonds Gain Favor on Potential Steady Income: Muni Credit

Ending a $7.1 billion dispute between states and cigarette makers may prevent future litigation and provide tobacco-backed bonds with more predictable income streams.

The bonds rallied yesterday after reports that tobacco companies tentatively agreed to settle a disagreement dating to 2003. The fight stemmed partly from company claims that market- share erosion reduced the amounts they’re required to pay 46 states under a 1998 agreement tied to medical-related expenses.

“If there’s a settlement, that alone will be positive, because it will put an end to that open-ended question — are states going to lose $2 billion, $3 billion or $7 billion?” said Richard Larkin, director of credit analysis at Herbert J. Sims & Co. in Iselin, New Jersey. “Most people have had to assume that all this money is at risk.”

States have more than $107.6 billion of outstanding bonds backed by the payments, made annually in April, according to data compiled by Bloomberg. Tobacco companies made $6 billion in annual payments this year, down from $6.4 billion in 2010 and $7.6 billion the year before, said Alan Schankel, director of fixed-income research at Janney Montgomery Scott LLC in Philadelphia, in a research note yesterday.

If a settlement occurs, it means tobacco companies are unlikely to withhold anything from their annual payments in the future, Schankel said in a telephone interview. The agreement would set rules on how states collect fees and taxes from manufacturers that didn’t participate in the 1998 accord.

‘More Predictability’

“It gives a little more predictability to future revenue streams,” Schankel said.

State attorneys general discussed the dispute yesterday at a meeting in Chicago. Nanci Gonder, a spokeswoman for Missouri Attorney General Chris Koster, said an agreement has been proposed, declining to provide details.

Tim Pynchon, who oversees $3 billion of municipal bonds for Pioneer Investment Management Inc. in Boston said yields on tobacco bonds were down as much as 25 basis points yesterday. A basis point is 0.01 percentage point.

California tobacco bonds maturing in June 2045 yielded an average of about 6.2 percent yesterday, down from 6.5 percent June 20. Similar Ohio securities due June 2024 yielded an average of about 7.9 percent, down from 8.1 percent.

“This event today is mostly positive,” Pynchon said. “I want to see the details, but I do think it will act towards freeing up the sector to see better prices over the near or midterm.”

Longer Maturities

Long-dated tobacco bonds have been trading to yield around 9 percent, as prices fell following the market selloff that started in mid-November, Pynchon said. A year ago the debt traded around 8 percent, he said.

The participating states claimed the money after tobacco companies agreed in 1998 to reimburse them $246 billion for treating smoking-related illnesses. Since 2005, Reynolds American Inc. (RAI) and Lorillard Inc. (LO) have put a portion of their payments into an escrow fund, saying that they’re entitled to refunds because they’ve lost market share to other producers such as National Tobacco Co., which didn’t sign the 1998 accord.

If an agreement enables companies to take money out of the escrow fund, states will receive the balance, Larkin said. Including 2010 payments into the escrow account, a settlement would affect about $3.47 billion, he said.

States may get about $1 billion from the escrow fund, Schankel wrote. California, Virginia and Ohio, who said last month that they planned to use reserves to make December interest payments on their tobacco debt, may not have to if an agreement is reached, he said.

Following is a description of a pending sale of U.S. municipal debt:

CITIZENS PROPERTY INSURANCE CORP., Florida’s state-run property and casualty insurer, plans to sell $900 million in tax-exempt bonds as soon as Monday to finance claims for hurricane damage. This year’s storm season has the greatest chance since Katrina struck in 2005 of producing a cyclone capable of causing at least $18 billion in damage, according to natural catastrophe research firm Kinetic Analysis Corp. The bonds are rated A+, fifth-highest, by Standard & Poor’s. Citigroup Inc. is leading underwriters in marketing the issue, which may include short-term notes as well as floating-rate securities. (Added June 23)

By Sarah Frier
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