Smoking Bonds

Marilyn Cohen, Forbes Magazine, 05.01.00

A Miami class action could cost the tobacco industry $100 billion or more. That's the latest of the many legal problems besetting the cigarette peddlers, who face an onslaught of suits from cancer-stricken ex-smokers and their survivors. Not to mention a possible federal suit from the Clinton-Gore Administration. If the industry hoped to put the litigation to rest with its $206 billion settlement with 46 states, its hopes will be dashed.

But the news isn't all bad: Revenue keeps rolling in for the tobacco companies. If you own the companies' bonds, that's some comfort.

Still, a better idea is to invest in tobacco bonds issued by states and municipalities, which are backed by the revenue they will haul in from hapless citizens addicted to tobacco. (Ostensibly, the tobacco companies are paying, but the economic reality is that they are just collection agents.) New York City is the largest issuer thus far of what we might call tobacco consumption anticipation bonds, with $709 million outstanding. Other states and municipalities are close on its heels.

These are less risky than tobacco corporate bonds. If the crush of court decisions causes a tobacco company to go bust, at least there are other companies feeding into the settlement pools. Certainly, New York City has made clear it isn't guaranteeing these bonds should the tobacco revenue dry up. Nevertheless, if that happens, an interesting political question would arise. Would New York allow its issue to go unpaid?

A look at the yields from Philip Morris, RJ Reynolds and their smaller competitors tells you why you should forget about their bonds. The spreads against comparable Treasurys aren't sufficiently wide for the risk you assume.

Take Philip Morris bonds, due Feb. 1, 2006, yielding 8.9%. The 2.6-point spread over Treasurys creates a stale cigarette odor around these bonds. I think the same about the RJ Reynolds bonds, even though they yield 4.5 percentage points more than the Treasury. Reynolds lacks the diversified revenue of Philip Morris, which has Kraft food and Miller beer.

Now let's examine the tobacco settlement bonds. To begin with, you have to understand their unusual structure. They have two maturity dates. There's a "planned" maturity date, which hits sooner; basically, that's when the issuer intends to repay the principal, provided consumption remains stable and the tobacco industry is able to deliver its penance.

Next comes a "rated" maturity date, which can be a few years to many years from the planned date; that's the fallback date in case the companies don't come through. Say, because they are too strapped paying class-action plaintiffs, or enough people have quit smoking that the now-daunting cash flow slows to a trickle. Only if the bonds don't repay principal on the later rated date are they in default.

New York City's Tobacco Flexible Amortization Bonds (TFABs), underwritten by Salomon Smith Barney, have rated maturities running from 1 year to 39. Against a New York City general obligation bond maturing with the rated maturity date of the tobacco bond, the tobacco returns don't measure up. But with the earlier dates--when the issuers likely will deliver the principal--the tobacco bonds have a clear advantage.

For example, the TFABs issued by New York in November yield 5.3% to maturity in ten years. That doesn't beat a ten-year New York City G.O. (5.4%). Odds are, however, that the tobacco paper will pay principal at its planned maturity date in just five years. And its 5.3% yield smartly outdoes the New York City five-year, which now yields 4.75%.

Similarly, the five-year rated TFAB came to market at 4.65%, no bargain against the five-year New York City G.O. at 4.75%. The return improves when you use the TFAB's planned maturity date, in mid-2001. The New York City G.O. that's due then is yielding 4.2%, or 45 basis points less than the tobacco bond.

And remember, these tobacco bonds are municipals, meaning you don't pay federal taxes on the interest. Their tax-equivalent yields handily surpass those of ultrasafe Treasurys. For taxpayers in the top (40.8% *) bracket, the five-year TFAB's taxable equivalent yield is 7.9%; the ten-year, 8.95%. That's within hailing distance of what you get on tobacco corporate bonds. Five-year Treasurys currently yield around 6.2%; ten-years, 6%.

How are the New York bonds rated? As very creditworthy. The most conservative rating, from Fitch IBCA, is A+. (*) Includes effect of deduction giveback.

Marilyn Cohen is president of Envision Capital Management®, Inc., a Los Angeles fixed income money manager. Visit her home page at www.forbes.com/cohen.

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