Tobacco bond investors received more good news on the legal front when San Diego Superior Court Judge Ron Prager ruled that a California lawsuit, Brown v. Philip Morris et al, could not move forward as a class action. The suit was brought against the major tobacco companies by a group of plaintiffs who maintained they were duped by misleading advertising into believing that light cigarettes were a healthier alternative to “regular” brands.
This decision came on the heels of the federal appeals court ruling in favor of the tobacco companies charged in the Justice Department’s $279 billion civil racketeering suit. The ruling eliminated the largest potential financial threat to the Master Settlement Agreement (MSA) participants.
Litigation environment improving
As a result of these decisions and the general perception that the litigation environment for the tobacco companies has improved, prices on tobacco bonds have risen to 12-month highs, pushing yields on these securities down to the 5.75% to 6.00% range.
It has been quite a roller coaster ride for tobacco bond investors, who saw prices plunge and yields rise as high as 8.50% in March 2003 when the Illinois “lights” case, Price v. Philip Morris, caused a panic in this market sector.
The sell-off was precipitated by a Philip Morris statement saying that if it was forced to post a $12 billion surety bond, as ordered by Circuit Court Judge Nicholas Byron, the company would be forced into bankruptcy and be unable to make its scheduled MSA payment that supported the debt service on more than $20 billion of outstanding bonds.
At that time, while the “gloom and doomers” of the financial media were advising investors to sell these bonds if they owned them and avoid them if they didn’t, we encouraged risk tolerant bondholders to stay the course or add to their positions at these distressed levels.
In our April 2003 commentary, Strange Bedfellows, Good Allies, we suggested that the Philip Morris bankruptcy threat was a bit disingenuous and was really intended to get the attention of the attorneys general from the 46 states who fashioned the MSA, knowing full well that these funds were needed to narrow their state’s burgeoning budget deficits.
Prices have come full circle
Since then, prices of tobacco bonds have come full circle. Most of these issues are trading at or above their original issue prices.
To be clear, we are not suggesting that the litigation risks for the tobacco industry have disappeared, or advocating that conservative, risk-averse investors purchase these bonds. Notwithstanding the recent spate of good news, tobacco bonds have not been upgraded by the rating agencies. (Most tobacco bonds remain at the lowest levels of the “investment grade” category.)
Nonetheless, it is our opinion that the longer-term trend suggests that litigation risks are lessening and can provide suitable, risk-tolerant investors with approximately 25% more tax-free income than high-quality bonds, if they are willing to live with the volatility and price fluctuation that has characterized these issues.
Once again, the lesson to be learned from the tobacco bonds saga is one we continuously try to drive home at FMSbonds: Stocks and bonds are different. Bonds are bought for income and – other than in the rare event of default – the income keeps coming regardless of the bonds’ market price at any given time. Despite the negative press, bondholders have invariably been rewarded for their patience if they held the debt of an issuer that was secured by meaningful assets.
In our 35 years in the bond industry, we have observed that when the public is spooked into panic selling, astute investors are buying. A few examples that immediately come to mind are: New York City; Louisiana; Bridgeport, Connecticut; Georgia Pacific; Orange County, California; and, most recently, the State of California.
By the way, the media naysayers haven’t had much to say about tobacco bonds recently. In fact, they seem to have vanished into thin air.
Perhaps they have moved on to address their comments to General Motors bondholders.
