A slowdown in cigarette consumption declines, a settlement in New York with the big tobacco companies, and strong demand for risk assets is supporting a rally in the high-yield tobacco bond sector.
"In a market characterized by low rates and tight spreads, tobacco securitization bonds have provided a source of yield for various institutional accounts as well as for those high net worth investors who have appropriate risk tolerance and understand the dynamics of the sector," said Jeffrey Lipton, head of municipal research and strategy at Oppenheimer & Co.
Tobacco bonds, which have a track record of credit and pricing volatility, have performed "exceptionally well" in 2015, returning over 13% year to date, versus 2% for the broader municipal market, according to data Lipton cited from Barclays. He said tobacco bonds returned 13.43% as of Oct. 27.
According to Municipal Market Data, generic, 30-year triple-A general obligation bonds were yielding 3.07% as of Oct. 29.
As a result, demand for riskier paper, like high-yield tobacco, continues to increase amid ongoing interest rate uncertainty, other analysts said.
Timothy Milway, a credit research analyst on the municipal credit research team at BlackRock Inc., said the subdued expectations for federal funds rate increases have kept interest in high yield municipals elevated, and turned fund flows in that category positive in August.
Citing data from Standard & Poor's, Milway said tobacco outperformed other sectors with a total return of 11.28% year to date, versus a 2.09% return for the S&P municipal bond Index.
Meanwhile, Milway said the negative press regarding Puerto Rico may be shifting interest into tobacco, "where risk is more quantifiable."
The prolonged delay by the Fed has boosted inflows into high-yield municipal funds lately, agreed Michael Comes, portfolio manager and vice president of research at Cumberland Advisors.
"There's growing demand for risk assets in general," Comes said in an Oct. 26 interview. He noted that long high-yield tobacco paper fits the bill among yield-hungry investors as it is currently trading at yields between 7% and 8% in the secondary market.
Another highly liquid issue, according to Comes, is Ohio's Buckeye Tobacco Settlement Financing Authority bonds with a 5.875% coupon due in 2047 trading at yields ranging from a low of 6.89% and a high of 6.933% in the secondary market.
The recent price improvement in the high-yield tobacco sector has also led to historic valuations and strong relative value, analysts said. That rally is being sustained in part by the settlement reached on Oct. 20 between New York Attorney General Eric Schneiderman and the big tobacco companies, they said. The settlement will release $550 million from an escrow account to the state.
The agreement ends a decade-long dispute with tobacco companies and permanently addresses issues that have prevented disbursement of funds owed to New Yorkers following the 1998 Tobacco Master Settlement Agreement. The MSA requires the companies to compensate the 52 states and territories – including New York – for the public-health costs of smoking-related illnesses.
Roughly half of these funds will go to New York State, one-quarter to New York City, and one-quarter to counties outside the city, according to an announcement on Schneiderman's website.
The attorney general's office said 90% of previously withheld funds will be released by next April, while the manufacturers will get a discount on future payments expected initially to be less than $100 million a year.
The latest New York agreement, according to Milway, seems to have increased expectations for other states awaiting settlement, like Ohio. "Settled states have less risk than non-settling states," Milway said.
While the high-yield tobacco sector offers relative value, Barclays analysts Mikhail Fox, Sarah Xue, and Mayur Patel suggest investors reduce exposure to California, New Jersey, and short-dated Ohio tobacco bonds – the states that rallied in sympathy with the sector following last week's New York settlement.
They believe the rally gives investors an opportunity to reap some rewards and reduce their exposure to certain tobacco issuers. "We believe that the current market strength provides a good opportunity to 'quit smoking' and take some profits on MSA tobacco holdings," the analysts wrote in an Oct. 23 weekly report.
Lipton of Oppenheimer agreed that investors should seriously consider profit-taking at this time – especially given the significant returns of late, and "the probability of limited potential for further advances."
Still, the Barclays analysts are proponents of the high-yield tobacco sector at large based on its value and cheapness relative to the Barclays high-yield municipal bond index.
"In recent months, high-yield tobacco bonds have reached valuations not experienced in a few years. However, we believe the bonds still offer value at current levels," the Barclays analysts wrote.
They compared the performance of securities with effective maturities greater than 22 years – both to account for the higher duration of the high-yield tobacco index and for removing Puerto Rico related entities from the Barclays high-yield muni index.
As a result, they found that high-yield tobacco currently trades 127 basis points wider than the high-yield municipal index, which compares to the low of 63 basis points in March 2014.
Tobacco also looked attractive relative to the high-yield hospital, education, and industrial development and pollution control revenue sectors, the analysts noted.
"The sector has rallied over the past few months, but we think there still may be more room to go," the analysts also wrote in a weekly report back on Oct. 9. "In our view, the current move may be reflective of increases in cigarette shipments rather than crossover activity, as valuations within high yield corporates remain elevated."
Shipment volumes are up year-to-date through July, according to the Alcohol and Tobacco Tax and Trade Bureau, the analysts said. That compares to previous data from the National Association of Attorneys General that indicated that original participating manufacturer (OPM) shipments declined by 4% annually from 2001 to 2014.
"Shipment volumes remain a key variable in analyzing tobacco bonds, as MSA payments are subject to an adjustment based on OPM shipment volume," the analysts wrote.
With cigarette consumption declines averaging 3.3% the past 15 years, market sentiment may be buoyed by tobacco manufacturers' recent expectations for flat volumes in 2015, Milway noted.
This would lead to a more than 3% increase in payments in April 2016, due to the inflation adjustment, Milway said.
A state's percentage share of MSA revenue remains fixed regardless of the level of cigarette consumption within a particular state, according to Lipton, but, he pointed out that significant declines in statewide cigarette consumption could reduce aggregate MSA payments.
He said while cigarette shipments appear to be on the rise, previous consumption declines beyond forecast disrupted the cash flow for many of these deals and have drastically altered assumptions.
"While the cash-flow uncertainty may very well result in extended maturities, or default, for many of these bonds, the perpetual nature of the Master Settlement Agreement would suggest that principal payment would ultimately be met," Lipton said. "This is a critical factor that prospective bondholders must consider and there must be an appetite to assume that debt service may not be paid on schedule and that it is very difficult to assess timing."
Analysts said New York tobacco paper and older tobacco issues are currently in demand. "We are seeing strong demand for New York state tobacco settlement issues as cash flow prospects are strong and more cash is being distributed than out of April payments," Comes said.
Lipton said the tobacco bonds issued earlier tend to have a better credit structure given a more conservative financial profile and use of leverage. "Also, these bonds have had more time to pay down debt before the heavy cash-flow disruption took hold," Lipton said.
Despite the rally and strong performance lately, others say the current opportunity could be short-lived.
"A slowdown in the pace of smoking declines may also be helping tobacco bond prices, but a few months of data does not equal a trend," Alan Schankel, managing director at Janney Montgomery Scott, wrote in an Oct. 26 report.
