Despite the shortfalls, Ohio Debt Director Kurt Kauffmen believes bondholders have a strong chance of eventually receiving disputed payments from tobacco companies.
Despite the shortfall, Ohio Debt Director Kurt Kauffman said chances were good that bondholders would get disputed payments from tobacco companies.

For the third time, Ohio will be forced to dip into reserve funds to cover debt-service payments on its Buckeye tobacco bonds.

The state's shortfall has doubled every year since 2011, except for 2012, when Ohio was able to cover all the payments.

This year, budget officials expect to tap a reserve account for up to $31.5 million to cover the December Buckeye Tobacco Settlement Finance Authority payment, according to Ohio debt director Kurt Kauffman.

In 2011, the state dipped into reserves to cover a $7 million shortfall, and in 2013 the shortfall rose to $14 million, according to Kauffman.

"It's growing a little bit," Kauffman said. "It's the continued decline in tobacco consumption that's driving the lower payment," he said. "The payments are lower than originally anticipated due to the decline in consumption."

Ohio issued its $5.53 billion tobacco settlement bonds in 2007, through the Buckeye authority. The deal marked the state's largest borrowing and the nation's second-largest securitization of tobacco settlement payments.

Tobacco bonds are backed by payments made under a 1998 Master Settlement Agreement that requires tobacco manufacturers to make annual payments to states based on consumption and other factors. Tobacco companies have lowered their annual payments for several years amid smoking declines.

Domestic cigarette shipment volumes fell 4.9% in 2013, according to the National Association of Attorneys General (see table below). That's one of the largest declines since the group began keeping track in 1999 but it is still far smaller than steep 6.4% and 9.1% respective declines in 2009 and 2010, triggered by a hike in the federal excise tax in 2009 to $1.01 per pack from $0.39.

In a recent report, Moody’s Investors Service pointed out that under President Obama’s 2015 budget proposal, the excise tax would rise an additional 93% to $1.95. Judging from the sharp impact on shipments from the 2009 increase, a further hike of this magnitude would likely send shipments down much more than the longer term trend.

The Buckeye bonds are structured to withstand a 4% consumption decline, and are considered to have among the thinnest debt-service coverage levels in the sector.

Moody’s currently rates a number of the Buckeye bonds ‘B3.’

The bonds' final maturity is 2052, though the state originally projected the debt to be retired by 2034 as a result of turbo redemptions paid for with surplus collections.

With less money available for debt service, the rate of turbo redemptions is expected to slow or stop in future years, according to Kauffman.

Ohio's Buckeye debt-service payments total $320.2 million a year. The state has always been able to make its June principal-and-interest payment. It's the December interest-only payment that has suffered the three shortfalls.

The current balance in the reserve account is $369.6 million, below the liquidity requirement of $389.2 million, according to the state's disclosure notice.

It's difficult to predict the state's ability to cover future payments because of ongoing disputes between several states and the tobacco companies that are tied up in arbitration, Kauffman said.

Approximately $7.1 billion in disputed payments had been withheld from 2003 to 2012 with tobacco companies arguing that states failed to enforce provisions in the MSA designed to protect them from market share losses to non-participating tobacco manufacturers.

A 2013 arbitration ruling found Ohio and 10 other states lived up to the escrow enforcement terms. Those states are projected by some experts to also be winners in future arbitration involving 2004-2012 payments.

"We feel good about our chances of getting disputed payments amounts that are pledged to bondholders released in future years and help us restore our reserve funds," Kauffman said.

If Ohio drains its reserves, the bonds will remain outstanding longer than expected, exposing investors to what is called extension risk. The bonds have no state general fund support. They priced with low investment grade ratings in 2007 but the bonds have since fallen well into single-B, junk-bond territory.

The Buckeye Tobacco Settlement Finance Authority's benchmark tobacco bond with a 5.875% coupon maturing in 2047 traded at a yield of 7.69% on Thursday, according to data provided by Bloomberg. This year the yield hasn't dropped lower than 7.28% it fell to on March 5.

The yield had dropped to 7.34% in early Monday trading, according to Bloomberg.

Ohio used proceeds from the securitization to pay for school capital projects for roughly five years. The state had spent all proceeds by early 2012.

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