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Wednesday 20 February 2019
Perspectives, Investment Talks
Jonathan M. Chirunga
On November 23, 1998, the Master Settlement Agreement was entered into among the Attorneys General from the 46 Settling States and 6 US territories, and the four largest tobacco companies at the time: Philip Morris, Inc., R. J. Reynolds Tobacco Company, Brown & Williamson Tobacco Corporation, and Lorillard Tobacco Company (collectively known as the “Original Participating Manufacturers” or OPMs). Today, after mergers and acquisitions, the OPMs are Philip Morris, Inc., Reynolds American BAT, and Imperial Tobacco. Philip Morris and Reynolds American together represent 83.99% of the cigarette industry market share in the US. Subsequent Participating Manufacturers (SPMs), represent another 9.13% of market share.
The MSA resolved cigarette smoking-related litigation between the Settling States and the OPMs, released the OPMs from past and present smoking-related claims by the Settling States and provided for a continuing release of future smoking-related claims. In exchange, the Settling States received certain initial payments, and receive MSA payments that are made in perpetuity. The MSA also imposed certain tobacco advertising and marketing restrictions on the OPMs, along with other limitations. Under the MSA, the Settling States and all Participating Manufacturers agreed to settle their respective lawsuits and potential claims pursuant to the terms of the agreement.
The resulting funding from the MSA includes the following for Settling States and their citizens:
In 1999, the Settling States and territories began issuing Tobacco Settlement Bonds backed by the annual MSA Payments received by the borrowing entities. There have been more than $40 billion of Tobacco Settlement Bonds that have been issued. To date, there have been no monetary defaults in the Tobacco bonds sector. Tobacco bonds are considered to be high yield bonds because of the following:
Even after the MSA settled, the tobacco bond sector continues to face pressures regarding regulations. In October 2018, the US Food and Drug Administration (FDA) announced that it may attempt to ban menthol cigarettes to assist with curbing the introduction of smoking to youth in the US. This headline-grabbing announcement temporarily caused a dislocation in the municipal high yield market, given that 16.3% of the Bloomberg Barclays Municipal High Yield Index, a broad measure of the high yield bond market, is composed of tobacco bonds, and that menthol cigarettes comprise about 30% of the US, cigarette market. History suggests that any such bans by the FDA would require several years of supported studies and research before such actions would be implemented. Moreover, in the past, tobacco companies have lobbied and vigorously challenged such suggested actions through both policy and litigation. Therefore, we believe these actions are very protracted and provide ample time for markets to digest and respond to projected resolutions.
The tobacco bond sector is the second most traded sector in the municipal high yield market behind Puerto Rico bonds. During periods of market stress, tobacco bonds have provided strong liquidity for the municipal high yield market, mitigating the effects of short-term disruptions.
Tobacco settlement bonds historically have had higher average annual total returns with less volatility, as measured by standard deviation, than both the S&P 500 Index and high yield corporate bonds. Standard deviation is a statistical measure of market volatility measuring how widely prices are dispersed from an average. The lower the standard deviation, the lower the volatility, and vice versa. Between January 1, 1999 and December 31, 2018, high yield municipal bond prices, as measured by the Bloomberg (BBG) Barclays High Yield Municipal Tobacco Bond Index, returned 7.6% (not taxadjusted) with a standard deviation of 7, while the S&P 500 returned 6.6% with a standard deviation of 9, and the BBG Barclays High Yield Corporate Index returned 5.6% with a standard deviation of 14.5.3 Of course, past performance is no guarantee of future results.
At year-end, tobacco bonds, as represented by the BBG Barc High Yield Tobacco Municipal Bond Index, yielded a favorable 6.14%, exempt from any applicable federal or state taxes.4
The role of tobacco bonds as liquidity provider to the municipal high yield market, and pressures that are inherent in the MSA payments that are pledged as security for the bonds, can lead to additional volatility within the tobacco sector. However, as highlighted in the chart below, MSA payments to the Settling States have been very stable over time, despite the decline in cigarette shipments.
To cushion the thin, but stable revenue stream provided by the MSA payments, most tobacco bonds are additionally secured by debt service reserves.
MSA payments and state cigarette tax collections have provided a very stable revenue stream to states. As shown below, states such as New York, Michigan and Ohio receive robust inflows from these two sources of revenues. Combined, the state of New York’s revenues from these two sources are about $1.8 billion, or 1.2% of its annual revenues. The state of Ohio’s combined revenues from these sources are about $1.2 billion, or 3.2% of annual revenues. These cash flows clearly demonstrate the reasonably stable base of revenues generated annually from the cigarette industry by these states.
Indices are unmanaged and their returns assume reinvestment of dividends, and unlike investment products returns, do not reflect any fees or expenses. It is not possible to invest directly in an index.
Bloomberg (BBG) Barclays Municipal Bond Index – A broad measure of the municipal bond market. BBG Barclays High Yield Index – Measures the performance of the high yield bond market. BBG Barclays High Yield Municipal Bond Index – An unmanaged index consisting of non-investmentgrade, unrated or below Ba1bonds. BBG Barclays High Yield Tobacco Municipal Bond Index – A sector-specific subset of the BBG High Yield Municipal Bond Index. BBG Barclays US Corporate High Yield Bond Index – Measures the USD-denominated, high yield, fixed rate corporate bond market. S& P 500 Index – A commonly used measure of the broad US stock market. Morgan Stanley Capital International (MSCI) EAFE (Europe, Australasia, and Far East) Growth Index – A commonly used measure of international growth stocks.
1 Source: Morningstar, Bloomberg (BBG) Barclays High Yield Tobacco Municipal Bond Index (1/1/1999 – 12/31/2018).
2 Source: Moody’s as of 1/1/1988 – 12/31/2018
3 Source: Morningstar data
4 Source: Bloomberg Barclays as of 12/31/18
Past performance is no guarantee of future results.
High yield bonds are subject to greater price volatility, illiquidity, and the possibility of default.
Diversification does not guarantee a profit or protect against a loss
Unless otherwise stated, all information contained in this document is from Amundi Pioneer Asset Management (“Amundi Pioneer”) and is as of December 31, 2019.
The views expressed regarding market and economic trends are those of the authors and not necessarily Amundi Pioneer, and are subject to change at any time. These views should not be relied upon as investment advice, as securities recommendations, or as an indication of trading on behalf of any Amundi Pioneer product. There is no guarantee that market forecasts discussed will be realized or that these trends will continue. These views are subject to change at any time based on market and other conditions and there can be no assurances that countries, markets or sectors will perform as expected. Investments involve certain risks, including political and currency risks. Investment return and principal value may go down as well as up and could result in the loss of all capital invested.
This material does not constitute an offer to buy or a solicitation to sell any units of any investment fund or any service.
Date of First Use: July 10, 2019.
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