Iowa has joined the growing list of tobacco settlement bond issuers who have refinanced all or a portion of debt secured by payments from the Master Settlement Agreement between 46 states and the major cigarette manufacturers.
You may recall that in July, the state of New Jersey announced plans to pre-refund $1.65 billion of its tobacco debt. In a commentary at the time (“Garden State Comes up Roses for Bondholders”), we said that if interest rates remained favorable and if there were no major legal setbacks for the tobacco companies, the New Jersey issue would prove to be the first of many tobacco bond refundings. In the past six months, a number of other issuers have announced similar intentions, while California and New York have already refinanced a portion of their tobacco debt.
WIN-WIN SITUATION
Iowa recently issued $824 million in new tobacco settlement bonds to refinance $644.3 million outstanding tobacco bonds. Iowa Treasurer Michael Fitzgerald anticipated that the refinancing would provide savings of $150 million to be used for schools, economic development and improving water quality, without increasing the state’s debt service.
It is also a windfall for bondholders, who, because of the pre-refunding, see the characteristics of their bonds change dramatically. Their Baa-rated 5.60% bond due in 2035 became a AAA rated bond, secured by treasury bonds, with a final maturity date of June 1, 2011. This upgrade in quality and shortening of maturity of the original 5.60% bonds causes them to trade at a considerable premium.
Because of the jump in price, clients who sell these bonds are able to purchase higher coupon tobacco settlement bonds from another state and increase their annual tax-free income, with no additional cost.
An investor who owned $100,000 of Iowa 5.60% bonds was able to trade them “even up” for $100,000 of New Jersey 6.125% tobacco bonds. The investor’s annual tax-free income increased by $525.00 per year while the total dollars invested are working at a considerably higher yield than they would be if the investor retained the now short-term, escrowed Iowa bonds.
DOMINO EFFECT
One interesting result of this exchange is that the New Jersey bonds are also candidates for refinancing if interest rates remain stable and there are no major shocks on the legal front for the tobacco companies. This could result in another handsome profit for the bondholders and the potential to repeat this delightful scenario.
