(Repeating to additional subscribers)
By Robin Respaut
NEW YORK, June 24 The rapid growth of electronic
cigarette sales poses a rising but under-appreciated risk to
holders of as much as $96 billion of bonds tied to payments
tobacco companies make to U.S. states from a sweeping legal
settlement in 1998.
Tobacco bonds were already forecast by many analysts to
begin defaulting within the next 10 years. That's because
Americans have given up smoking at a faster rate than estimated
when most of the bonds were sold in the previous decade.
Cigarette consumption has dropped an annual average 3.4
percent since 2000 while many bonds were structured to withstand
consumption declines of only 2 to 3 percent.
But as smokers swap traditional cigarettes for tobacco-free
e-cigarettes and other vaping products, the smoking rate is
declining even faster and analysts now predict some bonds could
go into default before the end of this decade.
"If the decline goes to 6 or 7 percent, it will be very
quick," said Tom Metzold, portfolio manager at Eaton Vance
Investment Managers. "I think that the first ones are probably
five years away," he said in reference to defaults.
While still a small part of the cigarette market, sales of
e-cigarettes and vaporizers have already grown to be worth more
than $2.2 billion from next to nothing four years ago. By some
estimates, they will capture more than half the smoking market
within a decade, and tobacco companies are already jockeying for
leading positions as that change unfolds.
"We believe consumption of e-vapor will eclipse consumption
of combustible cigs over the next decade as technology
improves," wrote Bonnie Herzog, analyst at Wells Fargo, who has
tracked the tobacco industry for years, in a recent report.
Last month, Reuters reported that Reynolds American Inc.
and Lorillard Inc., the second and third U.S.
cigarette makers, were exploring a merger. Lorillard's leading
blu e-cigarette brand, which has roughly 50 percent of the U.S.
market, is seen as one of the appeals of the deal to Reynolds.
Under the Master Settlement Agreement, or MSA, struck 16
years ago between the biggest U.S. tobacco companies and 46 U.S.
states, the companies make annual payments to the states using a
complex formula tied to U.S. tobacco shipments. The accord ended
years of litigation brought by the states, which had sought to
recoup healthcare costs for treating ailments tied to smoking.
The states with the highest populations, such as California
and New York, are owed the most. The majority of them arranged
to get much of their money up front by selling bonds and
pledging the annual payments to the bond holders.
The only problem is that as tobacco shipments decline, so do
the payments. And sales of e-cigarettes, which now appear to be
helping to accelerate the tobacco-consumption decline rate, are
not counted as cigarette sales under the MSA.
The outlook for tobacco bonds is so dire that a forecast
last month from Moody's Investors Service predicted 65 to 80
percent were headed toward default.
ALREADY AT RISK
Tobacco bond analysts have blamed the decline in consumption
of cigarettes on public smoking bans and new excise taxes, until
Last year, cigarette shipments dropped by 4.9 percent, the
biggest decline since the government passed a federal excise tax
in 2009, a drop some blame on the rising popularity of the
industry's new tobacco-free alternatives, such as e-cigarettes.
"The only cause I can attribute it to is e-cigarettes," said
Alan Schankel, managing director of Janney Capital Market's
Fixed Income Strategy team. "I think they are having an impact."
In 2013, Americans purchased 13.3 billion packs of
cigarettes and 400,000 equivalent packs of e-cigarettes, versus
14.1 billion packs of cigarettes and 200,000 equivalent
e-cigarettes in 2012.
Wells Fargo Securities predicts the pace at which consumers
switch from traditional cigarettes to e-vapor alternatives will
surge in the coming years. It estimates that sales volumes for
traditional cigarettes in the U.S. will decline by 68 percent
over the next 10 years, while vapor cigarette sales will soar by
more than 13-fold in the same period.
The shift in consumer preference and the non-inclusion of
e-cigarettes in the MSA "creates an incentive for tobacco
manufacturers to encourage their consumers to switch to vapor
products," wrote Wells' Herzog.
For Eaton Vance's Metzold, the recent takeover buzz in the
industry confirms to him that e-cigarettes are where the
companies see their future, at least in the U.S market.
"Here's your catalyst," said Metzold, who sold all of his
tobacco bonds more than a year ago. "Tobacco companies are
buying the e-cigarette companies."
Lorillard acquired blu for $135 million in 2012, and also
bought the UK e-cigarette brand SKYCIG for $49 million. Reynolds
began distributing Vuse e-cigarettes in June and the No.1 U.S.
tobacco company, Altria Group Inc, is soon due to roll
out its e-cig brand MarkTen nationally.
NOT EVERYONE'S A BELIEVER
Still, not everyone is convinced about the e-cigarettes boom
and the likelihood of early default on the bonds.
"E-cigarettes are not a real replacement. They are another
tool for people to quit smoking, but they are not a substitute.
To me, it's a fad," said Dick Larkin, senior vice president and
director of Credit Analysis, himself a smoker. "E-cigarettes are
a threat to the MSA, but I don't think they are a material
And the bonds are enticing for some, largely because they're
so cheap and offer juicy yields at a time when high rates of
return in the fixed income market are relatively scarce.
Boston-based investment firm Loomis Sayles bought tobacco
bonds several years ago when they were trading at deep
"I don't think you can say with 100 percent certainty that
e-cigarettes will supplant normal cigarettes. How does anyone
even know that?" said Steven Bocamazo, credit research manager
and senior research analyst at Loomis Sayles. "They have a small
market share and, while growing, it isn't the big threat that
everyone is making it out to be."
Tobacco-settlement debt currently counts among the
highest-yielding in the municipal bond market.
The Standard & Poor's Municipal Bond Tobacco Index sports an
average yield to maturity of 6.24 percent for the $23.9 billion
of bonds it tracks. By comparison, S&P's index for general
obligation muni bonds has a yield of just 2.9 percent.
But, even with a rally underway this year - the S&P tobacco
bond index is up more than 13 percent - most continue to trade
at distressed levels, reflecting their perceived default risk.
Moody's rates around 80 percent of all tobacco bonds at "B1" -
which is four notches below investment grade - or lower.
"There are fund groups like ourselves, that said, 'We don't
like what is going on here, we're getting out,'" said Metzold.
SOME STATES SOFTEN THE BLOW
The softening revenue flowing to the bonds from weakening
consumption trends has prompted some states to step in to
support the bonds.
Earlier this month, New Jersey announced it would draw $12.5
million from reserves as a result of "insufficient tobacco
settlement revenues" in April. Ohio and Virginia made similar
announcements in May.
To further bolster payments, some Democrats in Congress want
to fold e-cigarettes into the MSA, arguing the payments gives
states "a powerful tool to stop e-cigarette makers from
targeting youth." (Link: 1.usa.gov/1lDdv2k)
But many states haven't spent the $100 billion received so
far in tobacco settlement money on its intended use - to cover
healthcare costs generated by smoking. Only 14.6 percent of the
funding generated by tobacco settlement and state taxes are
spent on causes recommended by the Centers for Disease Control
and Prevention, the Campaign for Tobacco-Free Kids found.
Instead, states like New Jersey, New York and New Mexico
have used some of the money to prop up general fund revenues or
to service debt, among other things, according to the public
policy group, State Budget Solutions.
Among state policy makers, the rise of e-cigarettes has
caught the eyes of some but has not yet registered widely as a
Spokespersons for California's Department of Finance and New
Jersey's Treasury Department said they were monitoring the
growth of e-cigarettes and both agreed it was "premature" to
forecast how the new product would affect future MSA payments.
Kurt Kauffman, debt manager for the State of Ohio, said the
state hadn't "reached the point of concern yet." Ohio expects to
tap up to $31.5 million from a reserve account to cover a
tobacco bond payment this year. "It's something that we pay
attention to and have an interest in following," said Kauffman.
(Additional reporting by Jennifer Ablan; Editing by Dan Burns
and Martin Howell)