Like teens sneaking cigarettes in a high school bathroom, institutional investors who own tobacco bonds seem confident of their continuing health - despite what appears to be cancerous headline risk and the dangers that prompted another ratings downgrade Aug. 28.

"We feel that the underpinning of the bonds - the Master Settlement Agreement - is pretty much bulletproof," said Thomas Spalding, vice president and senior investment officer at Nuveen Investments in Chicago.

B. Clark Stamper, president of Stamper Capital & Investments in Santa Cruz, Calif., dismissed the fuss over Philip Morris USA threatening bankruptcy as a "blip" that is unlikely to result in bondholders failing to get paid.

"Since that story broke," Stamper said of the threat, "I think investors have actually gained some confidence."

He said the news caused many to closely study the downside protection measures, which he considers very sturdy, and "people now understand the credit quality better."

S&P chomps off two notches

The most recent jolt to the bonds came Aug. 28, when Standard & Poor's lowered its ratings on numerous transactions backed by the national tobacco settlement and litigation fees associated with the tobacco settlement. All the ratings - which, generally speaking, dropped two notches to BBB' from A-' - remain on watch with negative implications.

The tobacco bonds also remain on credit watch negative with Moody's Investors Service and Fitch Ratings. Both agencies slashed their ratings on the tobacco bonds twice in the past few months, and S&P's latest cut generally puts its ratings on par with the other agencies.

S&P, which conducted a conference call last week to discuss its downgrades, cited the adverse litigation environment for the tobacco industry in the U.S. and an expectation that smoking will continue to decline, at an even faster rate than originally anticipated.

One caller questioned the concern over declining cigarette consumption, saying the stress scenario for some of the first tobacco bonds issued with an A-minus rating assumed a 60% decline in smoking. "We're not anywhere near those assumptions that carried the A-minus," he said.

The analysts said cigarette shipments declined 3% to 4% per year since 1998, and the pace is picking up significant speed this year. First-quarter 2003 industry shipment volume was 12.9% lower than in the first quarter last year, according to figures from Management Science Associates.

"The potential weakness we now are assuming for volume declines are much more robust" than the scenarios that were considered in 1999, when the first bonds hit the market, S&P's Eric Hayden said during the conference call.

The decline is being fueled by increases in state taxes on cigarettes, anti-smoking legislation, greater awareness of the health risks and the declining social acceptability of smoking, the analysts said.

The ripples from Madison County

The tobacco bonds have had a troublesome spring and summer, with the autumn likely to bring more of the same. A lot of the ruckus revolves around a much-publicized case in Illinois, Price vs. Phillip Morris USA.

The smoke alarms started going off in March, when a judge in Madison County, Ill., awarded $12 billion in damages and legal fees to the plantiffs in the class-action lawsuit against Philip Morris (PM), a subsidiary of Altria Group Inc. PM was found liable of fraud for marketing its "light" cigarettes, such as Marlboro Lights, as being less harmful to health than its full-strength cigarettes.

The bonding requirement for PM to appeal the decision was initially set at $12 billion. PM threatened bankruptcy and even state officials interceded to request the amount be lowered. The judge subsequently reduced the requirement to $6 billion.

When the plaintiffs appealed the reduction, the Illinois Fifth District Appellate Court said the judge overstepped his authority in lowering the amount and remanded the issue back to him for further consideration. On Aug. 15, the judge reinstated the original $12 billion bonding requirement, but also granted PM a 60-day stay on posting the bond, giving it time to appeal the amount before the Illinois Supreme Court. The Supreme Court has yet to address the issue.

PM continues to maintain that posting the $12 billion would force a bankruptcy. "Philip Morris USA cannot post a bond in that amount and remain a viable business," William Ohlemeyer, the tobacco company's vice president and associate general counsel, told the Chicago Tribune in August.

A future full of "ifs'

Analysts and bankers are unwilling to speculate on the future of the asset class, saying too many variables are involved.

Sources said at least one deal backed by litigation fees, worth approximately $200 million, was in the pipeline a few months ago, but was shelved. One source said she heard there also might be some soft mandates for other litigation-fee deals that are waiting out the recent storm.

It was unclear whether the law firms would abandon their securitization plans, or how long they might continue to watch the market for more favorable conditions.

"From a law firm's perspective, the lower the credit worthiness of the bonds and investors' assessment of what the value is, the less attorneys are getting back through securitization for sales of all their fee awards," said Steven Moffitt, a director in the asset-backed group at Fitch. "In a way, it becomes a question of: one, can you find investors willing to take tobacco company risk on a long-term basis, and two, does the transaction make sense to the attorneys."

As the cost of financing the assets through securitization gets more and more expensive, attorneys are getting less and less money in return on a present-value basis, Moffitt said. "So does it make the same economic sense that it did when the bonds had a higher credit rating?" he asked. "That's a big question I don't know if we can answer."

There have been at least seven visible tobacco legal fee deals since the first emerged in 2001.

But if law firms are holding back on securitizing their payments for representing states against the tobacco companies, several states remain willing to brave the market with deals backed by their share of the tobacco settlement, even if it is costing them more.

States still dealing

All the uncertainty is forcing government issuers to mitigate the risk to investors with promises to prop up the bonds, in the event that tobacco companies fail to maintain their payment schedule under the Master Settlement Agreement.

New York successfully issued a deal in June, becoming the first to enhance tobacco bonds by backing them with state revenue. "I think what New York State did may be what we see more of," said John Hallacy, managing director, municipal research, at Merrill Lynch.

California, which is dealing with a massive budget crisis, already intends to imitate New York. It plans to issue $2.3 billion in tobacco bonds either this month or in October, with a provision allowing the state to use its general fund, if necessary, to make up for any shortfall bondholders experience from the tobacco companies. (California called off plans to issue tobacco bonds in April because market conditions would have made the sale too costly. Although it has the lowest credit rating of any U.S. state, California hopes that following New York's example of state backing will make the bonds more palatable to investors, and thus cheaper.)

The enhanced tobacco bonds also should help address another problem confronting the sector. Market players said that, given the heavy issuance of tobacco bonds in recent years, many investors are bumping up against their limits for buying more.

"One problem these tobacco bonds have is there were so many outstanding, it got to be more than 5% of the muni market," said Stamper, one of the municipal investors who had to restrict the amount he allocated to the bonds to 5% of his overall portfolio. With the ultimate credit being the tobacco companies, many investors had to count the bonds as if they were from a single issuer. But with a state guarantee, some will be able to count those bonds as coming from a different credit - enabling them to buy more.

Saying good buy

Triet M. Nguyen, president of the research firm Axios Advisors in Framingham, Mass., said the sector is a value for investors, with tobacco bonds trading at a discount to yield of 8.25% and attracting a lot of cross-over buyers, particularly hedge funds.

In his opinion, there is more than a 50% chance that PM will ultimately file for bankruptcy, but he is confident the tobacco bonds will withstand any resulting stress and remain investment-grade, barring an "overreaction" by the rating agencies. "We're comfortable with the fundamentals of the credit," Nguyen said.

Investors also seem to be comfortable, for the most part. Many are in wait-and-see mode, neither selling, nor buying.

"The good news is that we've shaken all the weak hands out," Spalding said. "Everybody that's uncomfortable with them, I think has already sold."

Several bankers and analysts said they heard from few jittery investors over the summer, despite the ruckus in Illinois. The asset-backed securities investors were particularly quiet, compared to buyers from the municipal market. "I was surprised at how quiet it was," said one banker. "I thought, Everybody involved in this is going to be calling us.' Instead, people are thinking, You know what? There'll be a lot of noise around this, but will it actually turn into something that affects the cash flow of my bonds? I guess not.' "

But those who were skeptics all along remain so. Some asset-based securities investors sound just as passionate when talking about tobacco bonds being bad as the American Cancer Society is about tobacco itself.

Tom Sontag, portfolio manager in charge of ABS and MBS at Milwaukee-based Strong Capital Management, said tobacco bonds are far too vulnerable to legal risk and other troubles that plague the cigarette industry.

"They fall under the category of things that are securitized that shouldn't be securitized," Sontag said.

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