Nearly three-quarters of senior tranches of the tobacco settlement bonds will default should cigarette consumption in the U.S. continue on its current rate of annual decline, said Moody's Investors Service in a report.Specifically, the rating agency finds that if the decline in consumption continues at a 3% to 4% pace, as Moody's projects, bonds constituting 74% of the aggregate outstanding balance of all the tobacco settlement bonds will default.
The finding is consistent with current ratings on the tobacco settlement bonds, 79% of which are rated at B1 or below, says Moody's in the report Sustained Decline in Cigarette Consumption Rates Will Cause Many Tobacco Settlement Bonds to Default.
"Characteristics that lead bonds to be vulnerable to a lower rate of decline include high leverage, long bond maturity, and low cash reserves," said Irina Faynzilberg, a Moody's vice president-senior credit officer and manager.
In the report Moody's presents consumption break-even decline rates for the bonds, which estimate the rate of decline that would lead a particular bond to default.
Moody's finds that 15 tranches representing 33% of the rated bond balance have an annual consumption decline break-even in the 2%-3% range, while 27 tranches representing 41% of the aggregate rated outstanding balance for all tobacco bonds, have an annual consumption decline break-even in the 3% - 4% range. The analysis assumes a constant rate of decline for the duration of the bonds' life.
Moody's calculates the break-evens for cigarette consumption decline rates by conducting iterative cash flow analyses to determine the default threshold for each rated bond, holding all other inputs constant. The default threshold is the highest constant annual decline rate for cigarette consumption at which each bond fully amortizes by its final maturity date without a payment default.
Moody's notes that although it does not assign ratings based on consumption breakevens, they do closely correlate with ratings.
Moody's will be updating its break-even analysis for the bonds annually.
Moody's rates 32 tobacco settlement securitizations, with an outstanding balance of $20.4 billion.
Tobacco settlement bonds are securitizations of annual payments that participating tobacco manufacturers remit to certain states and territories pursuant to the Master Settlement Agreement signed in 1998.