Municipal Bond Forum

As you know, virtually all states have seen revenue drops, leaving budgets unbalanced in face of the worst recession in 50 years. However, states, like Connecticut, have the ability to institute corrective actions to counterbalance hard economic times. As we have reported here in the past, the likelihood of a state defaulting on its debt is extremely remote.

In a recent report on Connecticut, Standard & Poor’s reaffirmed that state’s “AA” rating, commenting that high wealth and income levels, a diversified economy and budgetary flexibility to adjust revenues counterbalance a history of budgetary imbalances and high pension liabilities.

We would not recommend trading out of Connecticut to other states’ obligations for credit risk reasons. Connecticut’s credit profile and ratings represent an average state in terms of credit quality. A “AA”-rated state is expected to easily meet its debt payments in a timely fashion, and we do not foresee the need to change your investments based on Connecticut’s current financial problems, which we believe will be resolved over time as the economy improves.

As far as local government bonds are concerned, we have found that localities normally place a very high priority on paying their debt. Failure to do so would be illegal in most cases since the security pledge they make is legally enforceable. Local governments and their agencies would lose access to the municipal bond market in the future if they were to default on their bonds.

Typically, a community in distress will seek assistance from its state government if it is experiencing payment difficulties. In Connecticut, when Bridgeport was financially stressed several years ago, a financial control board was put in place to ensure that debt was paid and the city’s finances were put in order. As stressful as the current financial difficulties are for local governments, payment of debt service remains a high expenditure priority and this is reflected in the fact that virtually all local government bonds have investment grade ratings. We recently wrote about Standard & Poor’s efforts to raise the debt ratings of local governments to better reflect their strong payment history. We believe those track records will remain intact in the future.

I wish I could definitively project the decline in tobacco shipments in the future, but doing so would be difficult, at best. Each issue of tobacco settlement bonds was structured based on smoking and shipment projections made by Global Insights, a world-renowned economic consulting organization. Bond maturity schedules were structured to provide estimated ample debt service coverage for a "base" (expected) case, and one or more "low" cases in which cigarette shipments would be lower than anticipated.

The projections made by Global Insights took into account a 50-year known history of cigarette usage and incorporated historic rates of smoking decrease as well as projections assuming an acceleration of historic rates. Since the advent of the Tobacco Settlement in 1998, numerous state and federal excise tax increases have taken place, class-action court cases have been filed and mostly resolved, and tobacco companies have merged. Tobacco bond issues have seen their initial ratings downgraded by the rating agencies as their internal models have become more conservative. Yet, the tobacco bonds have continued to pay on time.

The problem with projecting future cigarette shipments is that we really have no way to predict human behavior when it comes to smoking. We do know there is a downward trend that has been existent since long before the tobacco settlement took effect. We also know that major rises in tobacco excise taxes have resulted in "bumps" in the rate of shipment declines for a year or so, before the rates of decline have returned to more traditional rates.

Reporting of tobacco shipment data has been spotty at best. The major tobacco companies, which are part of the settlement, but not party to the bond issues, have provided little data publicly in order to protect their proprietary business positions. States report shipment data separately and often with long time lags. The federal government also provides severely lagging data that requires refinement over time as tax stamp and other information trickles in.

All of this is to say that the current basis for future projections is unreliable. Despite several respectable studies by my industry peers projecting a sharp decrease in tobacco shipments over the medium – long term, the data just isn't reliable enough to reach such conclusions, in my estimation.

An article last month in The Wall Street Journal, titled "Downward Trend in Smoking Rate Stalls," reported that federal health officials found a slight increase in the smoking rate last year, a clear change from recent history. Is this unexpected finding an indication of a major change in consumer smoking behavior? An aberration? No one knows.

What we do know is that over the last 10 years, cigarette consumption has declined at a rate close to the upper end of the band of projected decrease. Beyond that, predicting the future with a high degree of certainty is impossible given the volatility of the data.

In his article, More Cities Earn S&P ‘AAA’ Credit Rating, Dr. Abrams is merely reporting that these rating changes occurred. He does not suggest that because a bond is “AAA” rated, it should be taken as the last word on its quality. Clearly, you have drawn your own conclusions as to their merit.

We should point out, however, that historically, underlying ratings of municipal bonds have proven to be consistently reliable, particularly when compared with the ratings on the mortgage-backed securities to which we assume you refer.