Underwriters, financial advisers, and lawyers interested in working on Illinois’ proposed sale of up to $1.75 billion of tobacco bonds to provide budgetary relief have until Aug. 27 to submit proposals to the state.

The state this week posted request for proposal (RFP) documents for firms interested in serving as senior managers, co-managers, financial adviser, bond counsel, underwriters counsel, and trustee. All are available at http://www.state.il.us/budget/rfps.asp.

The state wants to sell the bonds before the end of the year. Illinois’ budget struggles are driving the timing, which comes amid tough times for the tobacco sector. That’s because national settlement payments are lower due to a drop in consumption, promoting negative rating actions and raising concerns over looming defaults, especially for those bonds with longer maturities.

“It seems like one of the worst times to be selling tobacco bonds,” said Dick Larkin, a senior vice-president and director of credit analysis at Herbert J. Sims & Co. “Consumption is down and there’s been negative credit action with little room for downgrades before the bonds lose their investment grade.”

Standard & Poor’s has nearly $27 billion of tobacco bonds on review for a possible downgrade.
Illinois’ bonds would be sold through the Railsplitter Tobacco Settlement Authority.

Lawmakers created the special purpose corporation in the Emergency Budget Act of Fiscal 2011 signed into law earlier this year. It allows the state in fiscal 2010 and 2011 to transfer to the authority 100% of its right to tobacco revenues from the 1998 Master Settlement Agreement (MSA) between most states and the major tobacco companies in exchange for bond proceeds.

The agency is to be governed by three members: the Illinois budget director and two members appointed by the governor. The authority can sell up to $1.75 billion of special revenue obligation bonds payable from tobacco revenues with no more than a 19-year maturity. The authority is also empowered to do refundings.

The state would use bond proceeds for general fund expenses. Since it began receiving settlement funds, the state has put the money into a special fund that pays for anti-smoking programs and other health-related efforts. Under the 1998 agreement, Illinois was to receive $9.1 billion through 2025, but actual payments depend on a complex formula.

State debt manager John Sinsheimer has previously said officials are looking at issuing $1.4 billion of 17-year bonds to net at least $1.2 billion, securitizing roughly 40% of the state’s anticipated settlement revenues. Sinsheimer could not be reached to comment Thursday. The state expects to issue federally tax-exempt bonds. Interest will be subject to state income taxes.

Senior manager applicants are asked in the RFP to list team members and ­experience in tobacco securitizations, to provide details of a marketing plan for the bonds, and to provide their bank’s capital position and willingness to use its own ­balance sheet to support the transaction.

The RFP said Illinois expects to award the books to the firm with the top score based on various criteria, with the runner-up serving as a co-book-runner. Three more firms would be co-senior managers.

The tobacco bond sale was among a series of one-time, non-recurring revenues and maneuvers used to help address a $12 billion deficit going into fiscal 2011, which began July 1. The $50 billion budget also pushed off until fiscal 2011 repayment of $6 billion in bills incurred in fiscal 2010, and it taps $1 billion from surpluses in other non-general fund accounts. The budget also includes $1.4 billion in cuts.

Larkin wrote a recent report warning that the shrinking pool of smokers puts billions of dollars of tobacco bonds backed solely by MSA payments in jeopardy of default as soon as 2030. The payments act as collateral for nearly $56 billion of bonds, according to Bloomberg. Most of the bond structures were devised assuming modest declines in tobacco consumption over time and rising settlement payments.

Annual payments are based on a complex formula that adjusts for the size of the cigarette market, inflation, consumption and other factors. Analysts primarily attribute the higher-than-expected declines to increases in taxes on tobacco products by local and state governments and the federal government.

Americans smoked 325 billion cigarettes last year, according to the National Association of Attorneys General. That figure was a 9.3% plunge from 2008 and a decline of 4.3% annually over the past five years. Ohio’s tobacco sale in 2007 included a consultant’s projection of a 1.8% annual drop.

At the time, the Ohio consultant IHS Global Insight did warn that should the federal excise tax be increased, as it was, the fall in consumption would increase, for a five-year compounded rate of decline of 2.94%.

Global Insight said this week it attributed the even higher actual decline to the recession, higher gasoline prices, the proliferation of smoking bans in public places, increased state excise taxes, and restrictions on mail order cigarettes.

The sector’s turmoil has been reflected in yields and prices of tobacco bonds. A 2007 Buckeye Ohio Tobacco Settlement Financing Authority bond with a 2024 maturity traded this week at 84.77 cents on the dollar to yield 6.85% yield, compared to its original price of 96.58 cents with a 5.125% yield. The 2047 maturities traded this week at a price of 73.54 cents to yield 8.15% from an original price of 97 cents with a yield of 5.875%, according to Municipal Securities Rulemaking Board data.

The tobacco companies paid states $6.39 billion this year under the MSA, down from the $8.14 billion original base estimate in the agreement. That forced some states to reduce the accelerated repayment of some bonds with turbo redemption structures.

To maximize investor interest, Illinois will need to keep maturities short to avoid pricing penalties associated with extension risk and should leave a good amount of cash-flow coverage.

“The way to increase the value of the bonds is to keep the maturities shorter and set a higher break-even point at which the bonds can withstand consumption declines of at least 5%,” Larkin said.

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