Smoking These Bonds is Injurious to One’s Health

Some  years back, I blogged about the bond bubble leading to even churches issuing bonds. Now bonds are being issued that depend on manufacturers of the devil’s weed (I’m referring to tobacco. I know it’s an antiquated reference, but work with me here).

Tobacco bonds’ revenue streams depend on total U.S. cigarette sales. If sales fall, less money is doled out in a set proportion to each state. But Alabama used ultraconservative assumptions for its bonds. The securities will default only if cigarette sales in the U.S. fall more than 25% each year until the debt matures. [link]

Essentially, these are bonds that are backed by the 1998 settlement against the tobacco companies, and have been issued by other states before. To break it down, the tobacco companies promised to pay these states a certain amount of money over a number of years. The states then borrowed money from their citizens based on these payments coming in. But what if cigarette sales diminish to the point where the cigarette companies cannot make their payments any more? This is where the Alabama clause comes in, and the state will declare default on those bonds if sales decline by more than 25%. This is not the norm for these types of bonds — from that same article:

Many tobacco bonds were issued under the assumption that sales would decline about 2% a year. The decline last year was 3.5%, to 293 billion cigarettes, following a decrease of 3.8% in 2010 and 8.6% in 2009, according to Management Science Associates, an industry research group.

Alabama’s bond goes a step further than some other tobacco-debt sales that also have been designed to entice investors.

Not that this is going to stop investors from buying these bonds. In fact, these bonds are more volatile than other municipal bonds, and that is an attraction. The increased volatility results in an increased yield, and these bonds offer a higher yield in comparison to other bonds. In February, the yield was 5.66% compared with the 4.73% returned by S&P’s high-yield municipal-bond index.

Jim Dugan, co-chief investment officer of fixed income at Brown Advisory, which manages $1.9 billion in municipal bonds, said Alabama’s conservative assumptions on how much tobacco money it would get, combined with an attractive interest rate compared with other bond sales at the time, drew him to the offering.

“We didn’t get as many as we wanted,” Mr. Dugan said.

I know that volatility is not the measure commonly used in connection with bonds, but if only we can create a financial derivative that allows us to bet on the volatility of the tobacco bonds, then wouldn’t that be a sure thing? You heard it here, first.

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1 comment for “Smoking These Bonds is Injurious to One’s Health

  1. Darija
    April 11, 2012 at 5:37 pm

    I truly hope this won’t be used as some plea to save the poor disadvantaged tobacco companies that have been bullied relentlessly by big government. This isn’t the first time the Southern states have been backed by the tobacco industry, and this isn’t the first time the tobacco industry has been threatened with an apocalypse (a severe drop in sales and a sharp increase in the cost of capital) due to legislative restrictions. It is my belief… and experience… that smoking is enjoyable and will continue to be around just as alcohol has continued to thrive throughout western society. All of this to say: Yes, southern municipal bonds are feeling heat due to the economic downturn; but if a default is on the table because the handouts from the tobacco industry are off, their city and state governments better not dare pointing the finger at anyone but themselves.

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