The municipal market is still waiting for the first of what is expected to be several California tobacco settlement securitizations to come to market, but one county that had made strong progress toward pricing a deal has decided to step back from the starting line.

Laura Lockwood, director of debt management for Contra Costa County, said the county last month shelved a $125 million deal that it had been considering because the bonds' yields would have been too high relative to the rates that the county would have earned from an endowment that invested the proceeds in other municipals.

"Although we'd like to divest ourselves of tobacco-industry risk, we decided that it just didn't seem like a good business deal for us," Lockwood said during a panel on tobacco bonds at The Bond Buyer California Public Finance Conference in California last week.

A county task force including the controller, the treasurer, the tax collector, and the financial adviser had been studying the sector for 18 months, and officials had already selected Bear, Stearns & Co. to serve as senior underwriter.

But in the end, the county judged that it would experience too much "negative arbitrage" because relatively few investors are interested in the sector, which has been driving yields up. Lockwood compared the 75-basis-point spread between recent tobacco securitizations and other similarly rated municipals to a premium payment for an insurance policy that mitigates the risk from the tobacco industry, and then concluded that the $500,000 per year price tag was too high.

Lockwood said, however, that the county would likely revisit its decision next year and in subsequent years to see if spreads narrow on future deals.

However, that may not happen soon. Although almost a quarter of adult Americans continue to smoke, even after almost 40 years of government warnings, the corporate bond markets continue to penalize tobacco companies' bonds, according to Stuart Rossmiller, an equity analyst at Merrill Lynch & Co. He said tobacco companies typically have triple-A category financial fundamentals, single-A ratings, and trade at triple-B levels.

Ira Wagner, an asset-backed securities specialist from Bear Stearns, said the tobacco settlement securitizations boast stronger credit fundamentals than any one tobacco company's bonds because the revenues backing municipal deals are based on overall market consumption. But that positive is outweighed in investors' minds by the fact that the securitizations are less liquid.

Although Contra Costa has put off its deal, however, other California counties are expected to move forward soon. The major stumbling block - a dispute over the fees due to lawyers who represented the state's large counties and cities in litigation against the tobacco companies - may be settled in the next few weeks, said panel moderator Paul Webber of Orrick, Herrington & Sutcliffe.

On the bright side for the industry, Tim Swanson, a vice president at A.G. Edwards & Sons who covers the tobacco industry as an equity analyst, said the risk posed to the tobacco companies from several judgements in so-called "sick smoker" cases seems to be receding. He said the tobacco industry continues to post victories, building up a solid stack of precedents that will be difficult for future judges to ignore.

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