About Tobacco Settlement Bonds

By: Dr. Jay H. Abrams
Chief Municipal Credit Analyst

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About Tobacco Settlement Bonds

By Dr. Jay H. Abrams, Chief Municipal Credit Analyst

Despite new challenges to tobacco companies, tobacco settlement bonds remain good investments.

Unlike corporate bonds issued directly by tobacco companies, debt service payments on tobacco settlement bonds do not rely on the credit strengths of any particular tobacco company, but on the tobacco industry as a whole and the smokers who continue to use their products. We strongly believe that as long as the Master Settlement Agreement (MSA) remains in place, tobacco settlement bonds will prove to be superior investments. Here's why.

The tobacco industry has been, and continues to be, the subject of adverse publicity. Just recently, a Judge in Madison County, Illinois, awarded $10.1 billion to smokers in a class action suit against Philip Morris. As a result of a unique Illinois law that requires Philip Morris to post a $12 billion bond in order to appeal this ruling, credit agencies placed Philip Morris' parent company, Altria Group, on negative credit watch.

Tobacco bonds have generally been rated based on each agency's opinion of the tobacco industry's credit quality overall, as well as specific collateral issues present in each financing. Since Philip Morris represents approximately half of domestic tobacco sales, its fortunes serve, in many ways, as a proxy for the industry overall. As a result, a change in PM's ratings may cause unwarranted rating adjustments for tobacco securitization bonds as well.

Minimal Effect on Payment of Tobacco Settlement Bonds

We expect the current rating agency actions to have little effect on principal and interest payments of tobacco bonds. The reason is that tobacco settlement bonds are not obligations of Philip Morris or any other tobacco company. They were issued by special purpose entities created by each state that sought to securitize its payment stream under the tobacco settlement. The Master Settlement Agreement (MSA) was signed by the tobacco industry and 46 states and four territories in 1998, providing for $206 billion in payments to the States over a 25 year period as reimbursement for health and other related costs.

The financings that have securitized those settlements provide for a number of contingencies, including tobacco company bankruptcies, market shifts among tobacco companies and a decline in smoking. Typically, bond issues carry ratings reflecting the borrower's business prospects, financial strength and debt burden. Changes in these factors often bring about rating adjustments.

In the present case, any rating change that may occur to Philip Morris will reflect the rating agencies' opinion of that company's ability to service its direct debt. The effect on tobacco settlement debt is different. Philip Morris' commitment under the MSA is viewed as an "executory contract," according to rating agency legal advisors and, as such, would be highly unlikely to be interrupted even in the unlikely event of bankruptcy. To do so would invalidate the MSA and re-open lawsuits by all 50 states and territories that are party to the MSA.

So long as the payment stream is maintained under the MSA to the states, the likelihood of payment on tobacco settlement bonds relies solely on those payments. The structure of each tobacco settlement bond financing was based on "worst case" scenarios assuming the payment stream is less than expected, and was designed to still pay debt service in a timely fashion. Through "over collateralization," tobacco settlement bond issuers have pledged funding from their MSA payments sufficiently in excess of the amount necessary to meet debt service requirements so as to withstand a variety of dire scenarios, including the bankruptcy of a major tobacco company.

The Bottom Line

Ratings on Philip Morris are a proxy for ratings on the tobacco industry because of Philip Morris' leading market position. Tobacco settlement bonds are not a direct obligation of tobacco companies, but are payable from the MSA settlement stream payable to each state. There is a strong disincentive for tobacco companies to withdraw from the MSA during a bankruptcy, since the flood of new lawsuits would serve only to dramatically decrease those companies' financial flexibility even further. Finally, bond ratings on tobacco settlement bonds are based on the rating of the tobacco companies, not on the strength of the MSA revenue stream, as we think they should be. We know of no other bond where the ratings are so disconnected from the underlying security as in this case.

Due to the $12 billion bond that Philip Morris maybe forced to post, Standard & Poor's, one of the rating agencies, is likely to downgrade Philip Morris' parent company Altria Group, in the immediate future. Such an action could cause a lowering of tobacco settlement bonds as well. Nevertheless, as long as Philip Morris continues to participate in the MSA, we believe such a downgrade would be unwarranted and that bondholders will continue to be paid.

3/28/2003

*_ANALYST CERTIFICATION
SEC Regulation AC_*
I, Jay H. Abrams, hereby certify that the views expressed in these research reports accurately reflect my personal views about the subject securities and issuers. I also certify that no part of my compensation was, is, or will be, directly or indirectly, related to the specific recommendations or view expressed in these reports.*__*

*_IMPORTANT DISCLOSURE _*
These reports have been prepared and issued by FMSbonds, Inc. and approved for publication. Any unauthorized use or disclosure is prohibited.

These research reports are prepared for general information and are circulated for general information only. They do not take into consideration the specific investment objectives, financial situation and the particular needs of any specific person who may receive these reports.

Neither the information nor any opinion expressed constitutes an offer, or an invitation to make an offer, to buy or sell any securities or any options, futures, or other derivatives related to such securities ("related investments"). Officers of FMSbonds, Inc. or one of its affiliates may have a financial interest in securities of the issuer(s) or in related investments.



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