Rhode Island has already securitized 100% of the payments it receives from tobacco companies under the 1998 Master Settlement Agreement. Nevertheless, the state has found a way, with the help of Citigroup Global Markets, to refinance the debt and take some more money off the table.

The state’s Tobacco Settlement Financing Corporation is offering $593 million of new bonds backed by payments from participating tobacco manufacturers under the Master Settlement Agreement. Proceeds will be used to redeem approximately $523 million of tobacco settlement bonds outstanding that it issued in 2002, repurchase some of the notes issued in 2007, and make a payment of at least $20 million to the state, according to the prospectus.

The refinancing will also result in the release of some reserve funds from the 2002 transaction; the amount is not listed in the prospectus.

The offering includes a series of serial bonds maturing between 2015 and 2029 and a series of term bonds maturing between 2034 and 2039. Standard & Poor’s has assigned a preliminary ‘A’ rating to the serial bonds maturing between 2015 and 2024 and a preliminary ‘A-‘ rating to the serial bonds maturing between 2015 to 2029. Fitch Ratings expects to assign A ‘BBB+’ rating to all of the bonds; this is the one-notch above its rating for the tobacco industry, and the highest rating it assigns tobacco settlement bonds.

The deal is expected to price the week of August 4.

Interest rates are significantly lower than they were in 2002, when Rhode Island first securitized its tobacco settlement payments, so refinancing these securities frees up some funds for the state. But why would the state repurchase the 2007 bonds, which are subordinate to the 2002 bonds and deeply distressed? According to Robert Cusack, who sits on the board of the Tobacco Settlement Financing Corporation, the 2002 bonds cannot be redeemed without the consent of a majority of holders of the 2007 bonds.

“We need their permission to do this,” he said.

Citi, the lead underwriter for the deal, has already negotiated with a holder of the majority of interest in the series 2007 bonds to purchase a portion, at $8.50 per $100 of accreted value at stated maturity, of the series 2007A tranche maturing in June 2052, according to the prospectus. The total accreted value of this portion is $700 million, so Rhode Island will pay a total of $59.5 million.

The prospectus does not name the majority holder.

Citi has also offered to purchase another two other tranches of the series 2007 bonds, the series 2007B and 2007C, but it won’t tender them for cancellation, according to the prospectus.  Instead, Citi will sell them to the unnamed holder of majority of 2007 bonds. The series B bonds are not entitled to any payment until series A is paid; likewise, the series C bonds are subordinate to the series B. So retiring a portion of the series 2007A creates value for these subordinate bonds.

This complicated transaction has drawn inevitable comparisons with a controversial restructuring of distressed tobacco bonds executed this year by New Jersey.

However Cusack says that Rhode Island’s transaction benefits all parties involved, with the possible exception of holders of the 2002 bonds, which must find a new place to put their money to work.

“There are a lot of winners,” he said.

“We get cash out, the new bonds have a higher rating, and we increase the quality of the remaining outstanding 2007 bonds. We’ve also retired future liability; the revenue starts coming back [to the state] sooner, although it’s still pretty far in the future.”  Under the terms of the 2002 bonds, payments will not revert to Rhode Island until 2073.

Cusack, who is also a portfolio manager at Whalerock Point Partners, said that the commission wanted to both benefit the state and behave responsibly. To that end, the new transaction makes conservative assumptions about future tobacco usage. “The stress tests show that the new bonds will pay even if the decline in tobacco consumption is far in excess of current projections,” he said.

The 2014 bonds are structured to withstand an approximately 8.3% year-over-year decline in U.S. cigarette shipments, according to S&P. In its presale report, the rating agency said that this compares favorably with most of the previous tobacco transactions, which were structured to withstand about a 4% year-over-year decline.

Cigarette shipments fell 9% in 2009 after a federal excise tax increase took effect. Over the past few years, the decline has returned to about its historical average, although in 2013 the drop was close to 5%. Increased demand for electronic cigarettes was probably a factor in last year’s decline, according to S&P.

Refinancing the 2002 bonds could bring another benefit to Rhode Island, according to Cusack. The Tobacco Settlement Financing Corporation has negotiated for a cut of the payments received by the 2007 capital appreciation bonds that remain outstanding following the refinancing. That will allow the state to benefit from any upside in payments should Rhode Island receive any of the disputed payments currently being withheld by tobacco companies.  

Payments could also rise if sales of electronic cigarettes are eventually included in the Master Settlement Agreement.

Paul Burton contributed to this report.

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