Written by Chad Farrington, CFA – Columbia Threadneedle Investments
Tobacco bond yields can be addictive, but price volatility and default risk could make you ill.
Municipal tobacco bonds are one of the largest and most liquid segments of the high-yield muni bond market. They can offer enticing yields and periods of extraordinary returns. However, those features also come with high levels of price volatility. And because their repayment is dependent on cigarette consumption — and consumption is going down faster than expected — future defaults are almost certain, although perhaps not for a few years. So, are tobacco bonds good for investors or are they likely to go up in smoke?
How tobacco bonds came to be
The vast majority of these bonds were issued between 1998 and 2007, following the tobacco company settlements with 46 states to compensate for damages incurred due to smoking. States agreed to drop any future litigation against tobacco companies in return for annual payments based on cigarette consumption, subject to certain adjustments. Many states decided to securitize the future revenue stream and offload the risk of declining consumption — and future tobacco company solvency — on investors through the issuance of bonds. Today, tobacco bonds represent close to 20% of the Bloomberg Barclays High Yield Municipal Bond Index.
Will smoking declines snuff out payments?
Because of its addictive nature, smoking was initially thought to be fairly inelastic and unaffected by price increases that tend to depress demand in other products. This resulted in bond securitization structures that assumed fairly low levels of annual consumption declines. However, since the initial issuance, cigarette tax increases and stronger governmental regulation — including smoking bans in bars and restaurants — have combined to accelerate a decline in smoking.
The resulting declines in cigarette sales have been more severe than initially modeled in earlier tobacco securitizations and may portend future defaults. But as long as people are smoking cigarettes and the tobacco manufacturers remain in business, the odds of ultimate recovery may be higher than in other defaulted municipal bond situations — even if repayment is much later than scheduled maturity. This is because the pledge of securitization payments by the tobacco companies is perpetual.
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