FINANCIAL MANAGEMENT/Tobacco bonds provide financing options
Since 1998, there have been 14 issues backed by MSA receipts.
On November 23, 1998, 46 states, the District of Columbia, and various U.S. territories, cities and counties entered into a master settlement agreement (MSA) with the four largest U.S. tobacco manufacturers: Philip Morris, R.J. Reynolds Tobacco, Brown & Williamson Tobacco and Lorillard Tobacco. The MSA is a comprehensive agreement settling medical care cost claims against the tobacco industry in return for the industry making payments to the governments. Credit rating services have found that the additional revenues provided by the MSA receipts have had a positive impact on the governments’ finances.
Numerous local governments that are part of the agreement have issued, or are contemplating issuing, bonds backed by the MSA receipts. To date, there have been 14 such issues totaling approximately $3.9 billion.
The decision by a government to securitize its receipt of MSA monies will not affect that government’s debt rating, as long as the proceeds are not used inappropriately. For example, proceeds from the sale should not be used to initiate programs that would require significant funding from future tobacco receipts. Additionally, if the tobacco bonds are structured through a true sale to a special purpose entity, bondholders have no recourse to a government’s remaining resources, and credit rating services may exclude tobacco bond securitizations when used to calculate a government’s debt ratios.
The settlement agreement provides for five initial payments, ranging from $2.4 billion to $2.7 billion per year through 2003, and annual payments that began in 2000 and continue in perpetuity in amounts ranging from $4.5 billion to $9 billion per year. The initial payments and annual payments are adjustable based on a number of factors, the most important of which is domestic cigarette consumption.
If future U.S. cigarette consumption decreases relative to consumption in 1997, so do the payment obligations of the tobacco manufacturers. Furthermore, the payment obligations of the companies are legally several. Therefore, if one tobacco manufacturer defaults on a payment, the others are not required to make up the difference.
Issuing bonds backed by MSA receipts allows a government to hedge its bets against the possibility that future payments will diminish or be interrupted if Americans smoke less or the tobacco companies file for bankruptcy. If the tobacco bond is structured through a true sale of the government’s future MSA receipts to a special purpose debt issuing entity, then bondholders can look only to those receipts for security. The risks that MSA payments may diminish or be interrupted are, therefore, transferred from the underlying government to bondholders and are factored into the credit ratings of the tobacco bonds.
Of course, governments that issue bonds against their future MSA receipts also benefit by receiving a large, up-front sum of money that can be used for capital spending or any other purpose. Furthermore, the issuance of tobacco bonds is not subject to voter approval or debt caps.
On the downside, tobacco bonds are typically rated lower than the government’s general obligation bonds. That is because the tobacco companies — the source of the MSA payments — face risks such as litigation, competition, and reduced demand from negative advertising and smoking cessation programs. Therefore, the yield on a tobacco bond may be somewhat higher than the government would pay if it were borrowing on its own credit. Still, because of the benefits to governments that issue bonds, a number of deals are nearing completion, and a significant volume of tobacco bonds will likely be issued over the next several years.
The author is managing director of financial guaranties for New York-based Fitch.
