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Tobacco bonds face default risk as smoking drops

July 12, 2012|Bloomberg

The declining number of U.S. smokers is proving hazardous to the health of municipal bonds backed by payments from cigarette companies under a 1998 settlement with 46 U.S. states, Moody's Investors Service said.

The rating company projected that almost three-quarters of the $20.4 billion in tobacco bonds it grades will default if cigarette consumption declines 3% to 4% annually.

Tobacco bonds that have a high ratio of outstanding debt to annual payments from the companies, long maturities and low cash reserves are vulnerable to lower smoking rates, Moody's said today in a report. Moody's rates almost 80% of tobacco bonds B1, which is four levels below investment grade, or lower.

Payments by Altria Group Inc.'s Philip Morris unit, Reynolds American Inc. and Lorillard Inc. to states under the settlement back $101.5 billion of bonds, according to data compiled by Bloomberg.

Payments to states, which are based on U.S. cigarette sales, rose almost 2% this year, according to Mesirow Financial Inc. Sales declines of 2.9% in 2011 were offset by an inflation adjustment and growth in market share from companies participating in the settlement.

Cigarette use fell 9.2% in 2009 and 6.4% in 2010, according to Janney Montgomery Scott LLC, a Philadelphia- based brokerage. About one in five Americans smoke, according to the U.S. Centers of Disease Control and Prevention.

Virginia, California and Nassau County, New York, may use reserve funds to pay debt service on three tobacco-bond issues from 2006 and 2007, Mesirow said in May.

Tobacco bonds have earned 4.26% this year through June 30, compared with 4.1% across the $3.7 trillion municipal market, Bank of America Merrill Lynch indexes show.

Moody's projected that 33% of the tobacco bonds it rates can't withstand annual consumption declines of 2% to 3%, while 41% of the debt couldn't handle declines of 3% to 4%.

More-recently issued tobacco bonds have been structured by banks to withstand consumption declines of as much as 10%

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