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.
