The departure of "Bond King" Bill Gross from Pimco could cause a sell-off in tobacco bonds backed by the Master Settlement Agreement, market participants said.

Gross left Pimco on Friday for Janus Capital, where he is expected to manage a new bond fund.

Pimco's holdings of MSA tobacco are near $500 million, Citigroup analysts wrote in a report released on Monday. Citi predicted Pimco's positions in MSA tobacco are large enough that Gross' decision to leave could "cause substantial market volatility" in the securities and index. Under the MSA, the largest tobacco agreed to reimburse states for the medical costs associated with smoking.

"As we see, these holdings would be substantial enough to cause a market dislocation across a number of municipal sectors/products if liquidated over a short period of time," Citi wrote in the report.

A trader on the west coast agreed with Citi's prediction and said that when investors see that some holders of any security, especially one with as much headline risk as tobacco, are selling the perception will be that those holders will start selling a lot.

He pointed to the crossover investors selling tobacco bonds over the summer as an example of this sheep mentality, and said that once other investors realized crossover buyers were exiting the trade they tried to unload the tobacco bonds, too.

"[Gross leaving] is definitely going to widen the bid-offer, given there's another unknown in the market," he said.

He said the three benchmark tobacco bonds people should watch are MSA New Jersey, Ohio, and California bonds.

"They're more correlated to risk than other bonds because they are owned by more taxable accounts," he said. "They're a little more correlated to the taxable spreads."

California's Golden State Tobacco Securitization Corp. tobacco settlement revenue 5s of 2033 and the Buckeye Ohio Tobacco Settlement Financing Authority 5.875s of 2047 were two of the most actively traded CUSIPs on Monday, according to Markit. Both traded weaker even as the broader muni market strengthened.

The yield on the Golden State Tobacco 5s of 2033 yield rose by two basis points to 6.72%, and that on the Buckeye Tobacco 5.875s of 2047 rose by one basis point to 7.73%, according to Markit.

Dick Larkin, senior vice president and director of credit analysis at HJ Sims, said in an interview that he thinks that all tobacco bonds are overpriced and money is running out.

Tobacco bonds sold since 2010 and 2011 are in "pretty good" shape, he said, because they have built in so much excess coverage they can withstand a lot of shocks.

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