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Why does your firm continue to sell tobacco bonds, which you expect will go belly up?- G.R., Florida
Moody's had taken certain actions based on its reassessment of the credit of certain securities; we initially wrote about it as part of our responsibility to alert tobacco bondholders of those actions. As a successful bond investor, you are well aware that bonds are long term in nature and underlying fundamentals can change over time.
Nowhere in any article on our Web site do we suggest that we expect any of these bonds to go "belly up." We are simply reflecting that the rating services, which originally awarded certain tobacco bonds "investment grade" ratings, now consider them to be only suitable for investors – such as you – who have speculation as one of their investment objectives. We have a considerable number of clients who fall into this category, and we continue to accommodate their interests as well.
To reiterate, our purpose in writing about this change in status is to alert investors who have more conservative investment objectives and bought these bonds when they were rated in the "investment grade" category. The last two paragraphs of our recent article (“More Concern Over Tobacco Bonds”) specifically summarize our position:
"As a result of the overall strength of the municipal bond market, many tobacco bonds still command prices that belie their ‘speculative, below investment grade’ ratings.
"If you didn't exchange these bonds when they were originally downgraded and speculation is still not part of your investment objectives, we reiterate our suggestion to either sell or lighten up your tobacco bond holdings."
I have been told that it is more likely the tobacco bonds will go into technical default than outright default. Since the payments go on for perpetuity, if revenue is insufficient to make interest payments (or principal repayment), then bonds maturing in 2040 might not be repaid until several years later, but they will eventually be repaid. Also, why aren't states obligated to buy back some of the bonds? If revenue is less than they need to pay the interest, it means they issued too many bonds.- I.F., New Jersey
When these bonds were issued, the payment schedule that secured them was based on projections of future domestic cigarette consumption at that time. There were also certain enforcement procedures put in place to protect the participating cigarette manufacturers from loss of market share to non-participating companies.
In the interim, cigarette shipments have fallen short of estimates and the major tobacco companies have disputed payments, alleging a loss of market share and the failure of the states to enforce the protective provisions called for by the Master Settlement Agreement (MSA). These are factors that may cause bond maturities to be extended as well as raise the specter of outright default. Many of these issues are already in technical default, having dipped into reserves to remain current on interest payments.
Some states issued certain tobacco securities with a pledge to appropriate funds to cover any shortfalls down the road. These are referred to as "state enhanced." The bonds that have been downgraded by Moody's do not enjoy a state pledge and are dependent solely on the payments from the tobacco companies.
I agree with your article (“Don’t be Negative”): Don’t wait. But what do we invest in – low coupons, big premiums and no returns? Oh, seer, what is the answer!- S.M., Florida
Unfortunately we are not seers. If we had the ability to divine the future, a successful strategy for maximizing income would not be necessary.
We are, however, believers in buying good quality bonds at the best yields when investment funds are available. Usually this is accomplished with larger-coupon bonds priced to a call.
Our rule-of-thumb is to ensure the yield-to-the-call is higher than the yield available on a par bond maturing in that year. Similarly, we want the yield to maturity to be greater than available on a comparable new issue maturing in that same year. This means we derive the best value whether our bonds are called or go to maturity.
Remember, every dollar invested, including the premium dollars, are working at these higher yields. The reason bonds selling above par offer more yield is because they are too often misunderstood by individual investors. It is this supply-and-demand factor that creates opportunity.
This report is produced solely for informational purposes and is not to be construed as a solicitation or an offer to buy or sell any securities or related financial instruments. This report is based on information obtained from sources believed to be reliable but no independent verification has been made, nor is its accuracy or completeness guaranteed.