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Fixed-Income Insights

This unique corner of the muni-bond market has performed strongly over the past several years.

(Note: This article is from the forthcoming edition of The Muni Quarterly.)

Tobacco bonds are a unique municipal-bond sector, secured by revenues from a settlement between U.S. tobacco manufacturers and 46 U.S. states known as the Master Settlement Agreement (MSA).1  The MSA, signed in 1998, was negotiated by the original participating manufacturers (OPMs), including Philip Morris Inc., R.J. Reynolds, Brown & Williamson, and Lorillard. Today, the surviving OPMs are Altria and British American Tobacco.2 The MSA resulted in three primary outcomes: (1) compensation to states for tobacco-related health care costs; (2) curtailment of tobacco companies’ marketing activities; and (3) protection for tobacco manufacturers from litigation by the states. 

After states signed the agreement in 1998, bankers created an innovative bond structure to securitize the future revenues. Tobacco bonds were structured with serial bonds and “turbo term” bonds, which were anticipated to pay down from revenues in excess of required principal and interest resulting in a lower expected weighted average life (6 to 10 years) than the stated maturity (30+ years).  Some of the turbo bonds were turbo capital appreciation bonds, meaning they don’t pay current interest but accrete to a future value over the life of the bonds.

The securitized revenue stream was based on a complex payment formula from the MSA driven by consumption of cigarettes, U.S. inflation rates, and market share. At the start of the MSA, the OPMs sold 475.6 billion cigarettes annually in the United States. Due to the restrictions on marketing and wider public health initiatives after the MSA, the consumption of cigarettes began to decline, by an average of 2.1% annually from 2000 to 2008. Then, in 2009, the federal government increased the tax per pack of cigarettes from $0.39 to $1.01, driving an almost 20% decline over the next three years. By 2012, OPMs sold just over 250 billion cigarettes per year, almost 50% less than in 1998. Since that time, consumption declines have generally been between 3% and 4% annually. The declines have coincided with rising state taxes on cigarettes, an increase in the minimum buying age from 18 to 21, and restricting the points of sale in some states.

Smoke Signals
At the same time as consumption was declining, participating manufacturers began to lose market share to non-participating manufacturers (NPMs). Market share declined from a high of 99.6% in 1998 to a low of 94% by 2012. NPM’s market share grew so rapidly because they did not have to pay for the MSA agreement; therefore, they were able to sell cigarettes at a lower price. NPMs were required to pay an escrow payment equal to the cost of the MSA to level the playing field, but some states failed to enforce collection of the escrow.  In 2004, the OPMs began to withhold a portion of the payment for failure to enforce escrow collection, known as the NPM adjustment.   

Due to the declines in consumption and loss of market share, the revenues that backed tobacco bonds began to decline at a rate that caused an increased likelihood of default.  In terms of historical market performance, the rating agencies began heavily downgrading issuers in the sector around 2010 and into 2011 from investment grade to below investment grade. Broad declines in prices of tobacco bonds started before rating changes, but then accelerated after the downgrades.

However, investors had a unique security–even in the event of default, they were guaranteed a future revenue stream. In a default under a typical tobacco bond structure, all bonds, regardless of their stated final maturity, get paid their coupon and then a pro-rata share of their principal outstanding, if there is excess revenues available. If the revenues are insufficient to pay down the defaulted bond, investors would receive the cash flow in perpetuity.

As the consumption declines slowed and cash flows could be modeled more accurately, and market participants’ concerns abated, prices rose fairly dramatically in the sector. As an example of this outperformance, the Bloomberg Barclays’ High Yield Municipal Tobacco Index returned 10.12% annualized over the last 10 years (through November 1, 2018), while the Bloomberg Barclays’ Municipal High Yield Index returned 7.10%, with the Tobacco Index providing excess returns of 3.02% annualized. [There can be no assurance that this type of outperformance will continue in the future.] Given that the sector makes up roughly 17% of the municipal high-yield market, the sector also benefits from better liquidity than many other sectors in the muni high-yield space.


Tobacco Bonds Historically Have Outperformed the Broad High-Yield Muni Index
Values for indicated indexes, November 17, 2008–November 15, 2018

Source: Bloomberg. Performance during other periods may have been different. Other indexes may not have performed in the same manner under similar conditions. Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.
Past performance is not a reliable indicator or guarantee of future results. For illustrative purposes only and does not represent any specific portfolio managed by Lord Abbett or any particular investment.


Structural Shift
The tobacco sector has performed well for several years, but over the last year or so, a new factor has emerged, which has prolonged the rally in the sector. With historically low interest rates as bonds reach their optional call dates, issuers have been able achieve cost savings by refinancing their debt.  Issuers are further incentivized to refinance structures expected to default in order to recoup the cash flow after default, which would go to bondholders. The two largest examples of refundings in 2018 were the $3.1 billion New Jersey Tobacco Securitization Corporation issue and $2.1 billion issue from Golden State Tobacco Corporation (Calif.). By changing the structure and extending the maturity, the bonds can withstand a higher rate of consumption decline and get an investment-grade rating.

These refundings have had two important impacts on the market: (1) they reduced the supply of available high-yield bonds; and (2) they returned large amounts of cash to high-yield funds and investors who have been holding tobacco bonds.

We expect the refunding trend to be one of the most important components to excess returns in the sector. The biggest risk to future returns is regulatory issues, especially proposals by the U.S. Food and Drug Administration to ban menthol cigarettes and reduce the level of nicotine in cigarettes. We will continue to monitor consumption trends, regulatory issues, political developments, and the potential for refundings to help us select the best investment options within the tobacco-bond sector.


1Four U.S. states (Mississippi, Florida, Texas, and Minnesota) reached a separate agreement with the OPMs before the MSA.

2Altria is the parent of Philip Morris USA. Through a series of mergers, British American Tobacco acquired the assets of Reynolds, Brown & Williamson, and Lorillard.



This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The Bloomberg Barclays High Yield Municipal Bond Index is an unmanaged index consisting of noninvestment-grade, unrated or below Ba1 bonds.

The Bloomberg Barclays High Yield Tobacco Municipal Bond Index is a sector-specific subset of the Bloomberg Barclays High Yield Municipal Bond Index.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.


About The Author

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