Sin taxes are up, e-cigarettes are taking off and yields on tobacco bonds are rising.

For investors who haven’t already exchanged their tobacco bonds, we reiterate our suggestion (“More Concern Over Tobacco Bonds” and “Unloading Tobacco Bonds“) that they consider doing so, particularly if speculation is not an investment objective.

Dent in the wallet

In a move that is typical across the country, the mayor of Chicago recently unveiled a plan to hike its cigarette tax. With the 75-cent increase, Chicago would surpass New York as the city with the highest combined state and local cigarette taxes in the country.

The proposal is designed to raise additional revenue for the city, which may also prompt thousands of current smokers to quit and discourage young people from lighting up. A typical brand-name pack of cigarettes would rise to almost $13.

Consumption takes a hit

The viability of bonds backed by the Master Settlement Agreement between the major tobacco companies and 46 states depends on domestic cigarette sales.

A 10% increase in cigarette prices will reduce smoking by at least 3%, according to Congressional Budget Office estimates. Moody’s has already predicted that if consumption falls by as much as 4% a year, three-quarters of the $20.4 billion in tobacco bonds it grades will default.

Rise of e-cigarettes

As costs rise and smoking regulations become more stringent, sales of e-cigarettes, the battery-powered nicotine inhalers, are taking off. Earlier this year, Fitch Ratings predicted use of e-cigarettes may increase by as much as 50% in the next year, while Bloomberg Industries projects e-cigarette purchases could surpass sales of traditional cigarettes by 2040.

Market frowns

Meantime, market prices reflect the growing concern over tobacco bonds. According to Bloomberg, tobacco bonds maturing in 2034 issued by New York’s TSASC Inc. traded recently at an average yield of 9.49%, compared with a yield of 7.1% for junk-grade company debt with similar maturities.

Due to their substantially better-than-market yields, tobacco bonds have long been a favored holding of individual investors. But tobacco bonds have been regularly downgraded by the rating agencies, with most now rated as junk.

We continue to recommend that non-speculative investors either sell their tobacco bonds or pare their holdings.

James A. Klotz is the President of FMSbonds, Inc. Email the Author11/06/2013