INSIGHT AND PATIENCE PAY OFF FOR
TOBACCO BOND INVESTORS
It has been a long, winding and lucrative road for tobacco bond
investors since we originally recommended them in 2001.
At that time, we were intrigued that these high paying, new issue
securities not only produced 25% more current income, but also had
the potential to be refinanced by the issuer if interest rates declined.
Although we were confident that these controversial issues were
well secured, tobacco bonds displayed considerably more volatility
than we expected.
In March 2003, tobacco bond prices plunged and yields rose to 8.50%
in a wave of panic selling when Philip Morris threatened to declare
bankruptcy following an unfavorable ruling in the Illinois "Lights
Case."
While the financial media, prominent analysts and many major brokerage
firms questioned the viability of these bonds, we urged our investors
to take advantage of the adverse publicity, add to their positions
and lock in tax-free yields of 8.25% to 8.50%.
We are pleased that so many of our clients did.
Bonanza for bondholders
The state of New Jersey has announced its intention to refinance
its original tobacco debt. When this new refinancing plan is successfully
completed, it will take the form of a traditional "pre-refunding."
The state will float a new bond issue at a rate of approximately
5.00%. The proceeds will be used for the purchase of U.S. Treasury
securities to be placed in escrow, securing the $3.6 billion higher-interest
rate debt issued in 2002 and 2003. These issues will be escrowed
to their respective call dates and the bonds will be retired on
those dates. This will transform the original bonds into completely
different securities.
Although the coupon rate will remain the same, the bonds will have
six- to seven-year maturity dates and will be backed by U.S. Treasury
securities, inducing a dramatic jump in the price of these bonds.
All's well that ends well
Though clearly not for the faint of heart, this will be the culmination
of an extraordinary journey for original owners of this issue. After
buying bonds at 100.00 and watching the value drop to approximately
75.00, they now have the opportunity to sell their bonds at a spectacular
premium. (It should also be noted that during this period, these
bonds paid stalwart holders 20% to 25% more tax-free income than
other investment grade bonds purchased at the same time.)
Bondholders who elect to keep the escrowed securities will continue
to collect a steady stream of tax-free income until 2013, secured
by U.S. Government obligations.
The domino effect
We think the New Jersey deal is only the beginning. There are
approximately $26 billion high-coupon tobacco bonds outstanding.
If interest rates stay low and there are no unexpected setbacks
on the legal front, a substantial portion of this debt will also
be refinanced.
In addition to the windfall for investors, the refinancings will
serve to lower the debt burden of the states that have securitized
tobacco payments.
Since the introduction of tobacco settlement bonds, the majority
of industry commentators and financial media have pilloried their
merits. Our clients, on the other hand, appreciated the symbiotic
relationship between tobacco revenues and the states, as well as
numerous other factors supporting these securities.
Investor confidence has proven to be well founded, especially for
those who increased their positions when the prices of the bonds
were depressed. With tobacco bonds trading well above their original
issue prices, investors now have an opportunity to lighten their
holdings if they so choose.
Now the biggest danger we see for individual investors is the possibility
of getting trampled by the stampede of former naysayers scurrying
back to their drawing boards looking for ways to rationalize their
past opinions.
Bright future
Our research indicates that more than $10 billion of tobacco bonds
will be refinanced in 2007. California is already formulating plans
to retire its tobacco debt. Expect more good news from other states
as the year progresses.
01/18/07
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