If you don’t consider yourself a speculative investor, but still hold tobacco bonds originally purchased as investment-grade securities, Moody’s recent announcement may give you pause.

This month, the rating agency announced it had placed more than $20 billion of municipal bonds backed by revenues from tobacco companies under review. Moody’s is concerned that a proposed settlement between the major tobacco manufacturers and 17 states, the District of Columbia and Puerto Rico may reduce the cash flow that supports the bonds.

The proposed agreement is a result of Philip Morris USA, Lorillard Inc. and Reynolds American Inc. – the major signatories to the Master Settlement Agreement (MSA) – withholding funds earmarked to support these debt securities. The companies claimed participating states were not enforcing their pledge under the MSA to collect payments from non-participating manufacturers, who were increasing their market share of domestic cigarette sales. The tobacco makers held back $7 billion due under the terms of the MSA from the years 2003 to 2012.

Risk of discounted payouts

According to Moody’s, inherent in this recent agreement, “the joining states will receive only 54% of the approximately $4 billion share in dispute, significantly less than the 100% that we expected.”

Moody’s cautioned the December agreement raises the possibility that future payment settlements could potentially continue at less than 100% for the life of these long-term bonds.

Under the 1998 Master Settlement Agreement, major cigarette producers agreed to pay, in perpetuity, an amount equaling more than $200 billion for tobacco-related health care costs. In exchange, the 46 states that were party to the settlement agreed not to sue the companies for these costs in the future. Over the ensuing years, many of the states securitized the payments from the tobacco companies in the form of tax-free bonds, which were then offered to the public.  This, in effect, shifted any risk of a non-performance from the states to the bondholders.

As we noted previously (“Unloading Tobacco Bonds”), muni bonds backed by the MSA have long been favored by individual investors for their substantially better-than-market yields. However, the viability of the bonds depends on domestic cigarette sales, and as the number of smokers has declined in recent years, tobacco bonds have been regularly downgraded by the rating agencies. Now, disputed payments by the tobacco companies add an additional burden for bondholders.

As a result of the overall strength of the municipal bond market, many tobacco bonds still command prices that belie their “speculative, below investment grade” ratings.

If you didn’t exchange these bonds when they were originally downgraded and speculation is still not part of your investment objectives, we reiterate our suggestion to either sell or lighten up your tobacco bond holdings.

James A. Klotz is the President of FMSbonds, Inc. Email the Author 01/29/2013