Inflation isn’t so bad for sell-off-beaten tobacco bonds

(Bloomberg) — There’s a bit of good news for tobacco municipal bond investors who have been battered by the market’s selloff. The inflation that fueled the rout in the first place is, thankfully, increasing the incomes that support their holdings.

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Payments to U.S. states this year under a 1998 nationwide settlement with major tobacco companies rose 10%, despite a drop in cigarette sales, according to figures released late last month by the National Association of Attorneys General. That’s partly because under the regulations, companies must increase their annual payments to keep up with inflation.

Tobacco companies led by Altria Group Inc. paid about $7.3 billion to 46 states and territories, the most since 2013, the data showed. In addition to a one-time windfall from a court settlement, the 7% inflation adjustment helped offset a 6.1% drop in cigarette sales.

“This year’s inflation has been helpful for tobacco bonds from a payout perspective,” said Sarah Gehring, municipal credit analyst at UBS AG.

That said, it didn’t help the returns. Junk and unrated tobacco bonds have lost about 16.3% so far this year, the worst sector among high-yielding municipal debt, according to the Bloomberg indices. High-yield equity funds, suffering from a flood of investor redemptions, typically sell tobacco bonds first because they are among the most liquid high-yield equity securities. In contrast, investment-grade tobacco bonds have lost 8.9% this year, about the same as the broader market.

Investors have withdrawn about $8.2 billion from high-yield funds this year amid a sell-off in the bond market and are on course to break the record set in 2013, according to data from Refinitiv Lipper US Fund. Flows.

“A lot of the movement we’re seeing in tobacco is really technically driven,” said Dan Barton, head of municipal research at Insight Investment Management.

Illinois Colony

State and local governments have agreed with cigarette manufacturers to compensate taxpayers for decades of public health costs associated with smoking. Some governments have sold bonds, borrowing against the payments they expect to receive over the years from this settlement. Payouts on about $90 billion of outstanding tobacco bonds, at face value, are based on cigarette shipment volumes, according to data compiled by Bloomberg.

To be sure, most of the increase in payments to states this year comes from an additional $546 million that Illinois received to settle a dispute over money withheld by tobacco companies. Excluding the Illinois windfall, payments rose 2% on average due to the inflation adjustment, according to UBS.

The Tobacco Settlement Agreement requires manufacturers to increase their annual payments by at least 3% – or more if inflation is higher. Inflation increased by 7% in the 12 months to December 2021 and has since risen to 8.5%.

After rising in 2020, the first year of the pandemic, tobacco sales fell in 2021 with the end of federal pandemic stimulus payments, Gehring said.

And these declines continue. Altria estimated that the domestic cigarette industry’s shipment volume decreased by 6.3% in the first quarter of 2022.

Smoking habits

A combination of higher gasoline prices, consumer goods inflation and the recent conclusion of Covid-19 relief programs are likely weighing heavily on smoking habits, according to Bloomberg Intelligence analyst Kenneth Shea.

Last week, the Biden administration released details of a proposed ban on menthol cigarettes, which account for about 30% of cigarette sales in the United States, according to Barclays Plc.

Tobacco bonds issued in recent years are structured to withstand a significant drop in smoking. Illinois bonds issued in 2017 and rated A by S&P Global Ratings Inc, were structured to withstand an annual drop in tobacco shipments of around 18% without defaulting.

However, junk and unrated tobacco bonds — which have a higher ratio of outstanding debt to annual corporate payments and long maturities — are vulnerable to lower smoking rates and more sensitive to regulatory changes. Past vintages of the bonds assumed lower annual consumption declines of 3% to 4% and carried higher risk.

In addition to its annual payment of about $260 million, Illinois received an additional payment to resolve a longstanding dispute with tobacco companies over allegations that the state was not enforcing a law. aimed at protecting them from losing market share to companies that have not done so. sign the 1998 agreement.

Because the national settlement imposed significant costs on tobacco companies that participated, states passed laws assessing similar costs for cigarette manufacturers that did not participate to level the playing field. Disputes arose in Illinois and other states over enforcement, and as a result tobacco companies withheld payments.

In 2013 and 2021, arbitration panels found that Illinois had met its obligation. The settlement resolves the companies’ dispute with Illinois through 2028.

While the extra payout is positive for Illinois tobacco bondholders, prices for the $670 million bond were little changed as the muni market faces near-record outflows.

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Garland K. Long