May 2, 2018 / 6:32 PM / a year ago

ANALYSIS-Tobacco refundings erode high-yield muni debt, squeeze investors

 (Adds Reuters Instrument Codes for S&P indices)
    By Hilary Russ
    NEW YORK, May 2 (Reuters) - A series of big tobacco bond
refundings is reshaping the U.S. municipal junk bond market,
taking what has been a high-yielding staple and slowly turning
it investment grade.
    The change means that investors are increasingly struggling
to find the same high yields in comparable securities, a problem
compounded by even more investors flowing into the asset class.
    "One of the largest sectors in the high-yield universe is
shrinking," said William Black, senior portfolio manager at City
National Rochdale in Chicago.
    The specialized bonds stem from a 1998 settlement with
cigarette makers, which agreed to make annual payments to U.S.
states to cover medical costs of sick smokers.
    Over the intervening years, at least 21 states and
territories, and separately some cities, securitized that stream
of money by selling municipal bonds backed by the expected
    Since the start of 2016, states and cities have refunded
more than $6.2 billion of their old tobacco bonds, according to
Thomson Reuters data. Some of the deals are transforming
junk-rated debt into investment-grade assets and squeezing
high-yield investors. 
    When that money is returned to investors in a tobacco
refunding, it is harder for them to find similar places to put
it back to work. 
    "Mutual funds, along with the ETFs... are looking at the
likelihood of seeing cash backing into the portfolio when these
bonds are called away and not having a lot of choices for
replacement," said James Colby, who manages muni ETFs for
    In Colby's custom high-yield reference index, the weight for
tobacco is 15.25 percent, down from 20.70 in January 2016. The
shrinkage is a direct result of tobacco refundings, he said.
    Tobacco bonds comprised 15.5 percent of the S&P Municipal
Bond High Yield Index           at start of 2016 but have now
fallen to 14.4 percent, a 7 percent decline.
    Compounding the crunch is strong demand for high yield muni
funds, with investors pouring money in for eight straight weeks
and causing more people to chase after fewer tobacco bonds. 
    Flows into high-yield muni bond funds have been positive
every year since 2014, with $7.5 billion of inflows last year
alone, according to data from Lipper, a Thomson Reuters unit.
    Those investors are likely chasing yield. The S&P Municipal
Bond Tobacco Index          returned 8.40 percent over the past
year, compared with just 3.17 percent for the broader high yield
index and 1.64 percent for the overall AMT-free national muni
bond index            . 
    For a factbox of refunding deals, click here:             
    In 2007, issuers sold $16.9 billion of tobacco bonds
altogether, the biggest year of issuance on record, according to
Thomson Reuters data.
    Most bonds are callable after a decade, so some of these
deals are coming back for reworking since last year's 10-year
    Another $10.4 billion was issued in 2005 and 2006, adding to
the pile of tobacco debt now being refunded. 
    (For an interactive graphic of tobacco bond issuance, click:
    The same firm - Jefferies LLC - has underwritten every
tobacco deal since 2016. Jefferies declined to comment. 
    Over the years, many tobacco bonds have been downgraded as
more smokers than anticipated quit. That is because revenues to
the states from the 1998 settlement are based on the volume of
cigarettes shipped.
    But now, the ratings are moving back up as old bonds get
    The high ratings have mostly been driven by new cash flow
structures and, in some cases, higher payments from the tobacco
companies after the resolution of legal disputes, S&P structured
finance analyst Christine Dalton told Reuters.
    New Jersey refunded $3.15 billion of tobacco bonds in April,
exchanging speculative 'B' rated debt for investment-grade
bonds. The deal will generate $162 million in present value
savings for the state, said New Jersey Treasury spokeswoman
Jennifer Sciortino.             
    The state could use the cash. The second-lowest-rated U.S.
state, New Jersey needs nearly $1.6 billion of tax hikes to
cover its spending needs next fiscal year, Governor Phil Murphy
has said.
    States can benefit from using one-time revenues - like from
a refunding - for one-time expenses.
    "If there's money on the ground, you can't blame someone for
bending over to pick it up," said S&P public finance analyst
David Hitchcock.

 (Reporting by Hilary Russ; editing by Daniel Bases and Dan
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