The tobacco bond market took a series of hits last week, marked by a multi-notch industry downgrade from Fitch Ratings, which, on the corporate side, took R.J. Reynolds below investment grade. On the ABS front, Fitch further downgraded the entire sector, affecting approximately $18 billion in bonds.

Currently, Fitch's settlement-backed bonds - with top classes general at BBB' - enjoy a one-notch separation from the agency's industry rating, which is now at BBB-'. While these are closely aligned, as the payments to the master settlement are essentially payments by the industry to the states, Fitch believes that the participating tobacco companies are slightly more likely to honor their master settlement payments in bankruptcy than their unsecured debt, mostly because the contract to pay is executory, which means that if the tobacco company continues making payments, the States will not sue them again.

On Fitch's conference call last week, which was listened to live by more than 100 callers, Kevin Duignan of the ABS group indicated that it's possible the notching differential could change if the industry were to experience another major downgrade, though it would depend on the nature of the event triggering the downgrade.

One theoretical example would be a bankruptcy of one of the major tobacco companies, where the company immediately affirmed its intention to keep paying into the MSA. In this case, while the corporate rating would drop to D', potentially impacting the industry rating, there would be grounds to further separate the MSA-backed deals from the corporate credit of the industry.

"If that were to happen, we'd have a big uncertainty lifted," said Michael Dean, a managing director at Fitch.

According to Fitch, the tobacco industry showed an accelerated decline in operating earnings, volumes and revenues in the first quarter. RJR's consumption declined 8% to 10% in the first quarter, though that figure's meaningfulness has been debated, as it's understood that there was a spike in pre-price shipments last fall, such that the comparison number was inflated.

All the rating agencies are still closely watching the outcome of the Price case in Illinois, where Phillip Morris was initially required to post a $12 billion appeal bond, later reduced to $6 billion, regardless of the outcome of the appeals process. This case has the agencies concerned about future litigation risk and the ability of the companies to meet future liquidity demands as seen in Illinois.

Meanwhile, on the conference call, an investor posed what Fitch considers a fairly common question in tobacco ABS, specifically because of the industry rating link. Basically, investors note that some later vintage bonds benefit from a lower coupon expense related to lower interest rates. This results in higher enhancement levels, as the debt service is lower despite cashflows being tied to the same collateral pool.

"We get this all the time," said Dean. "No matter how many bells and whistles you put on a structure, the cashflow that supports these bonds is dependent on the industry rating." Even the rating on the last dollar of loss is capped on the credit of the industry and its ability to pay, per this methodology. "We don't upgrade, but our stresses allow them to issue more debt given the same collateral pool and same structure."

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