California, which has already raised the smoking age to 21 and may add a higher cigarette tax this year, can single-handedly affect the national consumption numbers that back tobacco settlement securitizations, said Richard Larkin, director of municipal credit analysis at Stoever Glass & Co.

 California's new, higher legal smoking age heralds more trouble for tobacco securitization debt, said an analyst who has followed the sector for years.

The legal tobacco purchase age in California rose to 21 years old on June 9.

"As an analyst covering tobacco bonds, I am concerned about anything that will reduce future receipts needed to repay debt," said Richard Larkin, director of municipal credit analysis at Stoever Glass & Co.

Raising the legal age for tobacco purchases by three years is expected to lower California's tobacco tax income by about $68 million a year, according to legislative analyses.

It could also have broader implications for other states.

Tobacco securitization bonds are backed by revenue U.S. tobacco companies agreed to pay under a 1998 master settlement agreement to compensate 46 states, Washington D.C., and Puerto Rico for expenses stemming from health problems related to tobacco use.

States have received more than $50 billion so far under the MSA, according to the National Association of State Attorneys General, which manages the agreement.

The bonds are secured by the states' share of revenue from the master settlement.

A lot has changed in the 18 years since the MSA.

"There are two trends right now, both disturbing, that have already led to several states having to use emergency cash reserves to meet minimum debt requirements," Larkin said.

The long-term trend for tobacco use is in decline, which poses problems for tobacco securitizations as a sector, Larkin said.

The two trends Larkin highlights are laws prohibiting public smoking, which California took further by raising the legal smoking age, and tax increases that raise the price of cigarettes, which have the economic effect of reducing sales and consumption.

In California, Larkin said, both of these dynamics will be factors if voters approve a new tobacco tax under a ballot measure that is expected on the November ballot; combined they could potentially reduce cigarette consumption and sales by up to 19% in the state, Larkin said.

Sales of cigarettes and other tobacco products in California, as in other states, have declined steadily, with tobacco excise tax revenue falling from its peak in the late 1990s.

The settlement revenue backing tobacco securitizations is based on nationwide consumption.

"But for a state as large as California, which it is estimated contains about 11% of national smokers, the reduced demand will be significant," Larkin said.

It is currently estimated that declines in national consumption must be less than 3.5% annually for most tobacco bonds to pay in full.

Between the already implemented change in legal smoking age, and the expected tobacco tax ballot measure, California could single-handedly take care of a 2.1% annual decline, Larkin said.

"One down, one to go," he said.

"I have seen studies that estimate in 2015 that smokers from 18-24 in California represent 15% of all smokers," Larkin said.

Larkin said the current price of a pack of cigarettes in California is $5.89. Studies show that an increase of 10% in the price of cigarettes reduces demand by 3.5%. In California's case, the proposed $2-per-pack tax would be a 34% increase. Using the multiplier, the tax increase alone could cause demand to drop another 12%, he said.

California's current 87-cent-per-pack tax rate ranks 36th among the states, according to the Campaign for Tobacco-Free Kids.

Larkin acknowledged that there is some overlap and double-counting in running such numbers, and that he would leave accounting for that to industry academics and experts.

Securitized bonds are supposed to be structured to deal with almost any future development and still have money to pay bondholders in full.

When the tobacco bonds were first sold in 1999, Larkin said, there were believed to be only two variables that would affect tobacco cash flow: inflation, which has a built-in 3% inflation adjustment, and consumption trends.

At the time, rating analysts and investors believed that consumption declines would be less than 2% annually, he said.

"I started covering tobaccos in 2003, and found that consumption declines were averaging about 4%, twice as bad as assumed," Larkin said. "Since 1998, the average declines have been a little more than 4%."

In 2005, a new dynamic reared its head: the tobacco companies began withholding between 10-15% of its annual payments under a permitted clause in the settlement, he said.

"At first, no one took these disputes seriously except me," he said. "By 2010, the rating agencies finally began to recognize that these disputes were not going away, and started downgrading them until most tobaccos were rated below investment grade."

In 2013, Larkin said, about 26 states decided to settle their disputes from 2003 for partial payments; about 16 states were exempted from litigation on 2003's dispute. Six states lost their cases in arbitration. Those disputes continue, even for this year based on 2015 consumption and sales, he said.

A handful of states are seeking to privately and individually settle their portions of the dispute with Philip Morris.

"With the confusion and unpredictability of all of these settlements, arbitration rulings, continued disputes and now privately negotiated side-settlements, any notion that these bonds were predictable securitized bonds with predictable cash flows is out the window," Larkin said.

Fitch so far is the only rating agency saying that, Larkin said.

Fitch Ratings said its May withdrawal of ratings on U.S. tobacco asset-securitization bonds, affecting over 40 tobacco issues from New York to California and Michigan to the U.S. Virgin Island, was prompted by uncertainty regarding changes in the terms in the Master Settlement Agreement.

"In my opinion, any bond ratings by Moody's Investors Service and S&P Global have to be suspect, because there are too many variables now to make any kind of educated guess as to what future Master Settlement Payments will be, in total, as well as to how they will be divided up among the states," Larkin said.

"Tobacco ABS performance is largely driven by payments tied to cigarette shipments," Moody's analysts said in an email statement this week. "However there are additional factors, including legal risks, which we have incorporated into our methodology and are reflected in our ratings."

Moody's most recent report on the sector, published Thursday morning, said that higher cigarette consumption in 2015 bucked a long-term trend.

"An increase in U.S. cigarette consumption in 2015, the first in nine years, is resulting in tobacco settlement asset-backed securities receiving larger payments from the tobacco manufacturers in 2016 than in 2015," Moody's analysts wrote. "The higher payments will help some tobacco settlement ABS pay down more quickly, although we maintain our expectation that consumption will continue to decline by 3% to 4% per year over the long term."

Higher cigarette shipments benefit tobacco settlement ABS because annual bond payments are based on the level of the previous year's cigarette shipments from manufacturers that participate in the MSA, Moody's wrote.

Moody's had said in a July 2015 report that declining cigarette shipments and industry consolidation were credit negative for tobacco bonds. It also said the average annual decline in shipment volumes is within expectations.

S&P declined to comment.

In past years, Larkin said he would do analyses based on that year's April settlement payments and allocations to states, Larkin said.

"At this point, I have no basis to make any kind of a realistic projection for national payments on the whole, as well as what any individual state's allocations will be in future years," he said. "Heck, I can't even figure out the basis for what states received individually this year: some states saw lower payments compared to last year, some saw higher payments, and one state (New York) saw their receipts double from $700 million to $1.4 billion. And all of this is confidential between the cigarette manufacturers and the states' attorneys general."

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