Smoking is bad for your health - Tobacco bonds will kill you

Bruce Krasting's picture
I think tobacco bonds are headed into the crapper. There’s about $56b of
them out there. Most of that is either in retail hands or in bond funds
that retail owns. This is likely to be a slow motion train wreck rather
than something that explodes into the headlines one morning. But it
will put a dent into some 401Ks. It already has.

By way of background on this let me diverge a bit and give you my side
of the tobacco story. I knew a fellow who was a mover and shaker in one
of the big US tobacco companies. Back in 1998 the tobacco companies
reached what appeared to be a very harsh settlement with the states. The
essence of that deal was that big tobacco would fork over a huge wad of
money and the states agreed not to sue for healthcare claims. At the
time the deal was inked I had a conversation with the guy. It went
something like this:

BK: Man you guys took it in the ear on this one. Good-bye dividends, goodbye profits. You guys got smoked!

Lucky Strike:
You have it totally wrong. This is a great deal for us. This is exactly
the deal that we hoped to achieve when we started this out. It looks
like we are big losers, but in fact, we are big winners.

BK: Huh?
That’s not what it says in the papers. They say you will have to fork
over ¼ trillion over the next few decades. How’s that such a good deal?

Lucky Strike:
You have to understand, there was a real possibility that tobacco would
become a controlled substance. If that had been the case we would have
folded the tent in the USA. But with this settlement we are guaranteed to be in business forever, and we are shielded from liability. We made a pact with the devil. In this case, the State Treasurers are the devil.

don’t get it. Sure there is a new source of revenue for the states, but
there is also the increased medical cost that goes with it. Where’s the Beef?

Lucky Strike:
This deal allows the states to securitize the future revenue from this
settlement. That means they can issue new bonds but they don’t have to
show it in their debt profile. The tobacco settlement is just a way for the states to get off balance sheet financing.
The guys on Wall Street are already ginning this up. The states can
issue billions of new bonds. The current crop of “Ins” will spend it. We used the State's greed to get what we wanted.

BK: But
this is all going to blow up if the states do that! Ten – Fifteen years
from now this is all going to come due. What happens if they hock the
future settlement proceeds and then we find that there are no proceeds?

Lucky Strike: If that were to happen it all goes Boom.
But I’m retiring in five years and those that inked this deal from the
states will be gone before the flameout. In the meantime, everyone is fat and happy.

BK: Oh. So that’s how things work.

Note: A lot of readers have said that I
dwell on the ‘dark side’. It’s true. Stories like this one are the
reason why. It’s not nice on the dark side. But when it comes to
politicians, money and Wall Street you’re safer with the dark view. You
don’t get surprised as much by what happens.

Back to June of 2011 and the cracks on all this are starting to appear, Some quotes from a recent Bond Buyer story:

The payments that cigarette manufacturers make to the states are dwindling as people smoke less, posing the latest setback to tobacco bonds.

“We saw a consumption decline that was above and beyond our base-case expectation,” said Aoto Kenmochi, a tobacco bond analyst at Fitch Ratings.
The precipitous
decline in payments threatens to leave some tobacco bonds outstanding
longer than expected. In the worst cases, the withering payments could eventually push some bonds into default.
Fitch has downgraded dozens of tobacco deals as the fading settlement payments have left tobacco structures with less of a cushion to tolerate further erosions.

Here a few charts on some outstanding tobacco bonds. If you want a high
current yield this is for you. But beware; you may never get your
principal back.

You can see from the pricing that these dogs have already been hit hard. More bad news is in front of these bonds.

The worst of the worst is the following. I have this on my Piece of S#*! list. Consider the insanity of this. Back in 2008 the State of Michigan borrowed $58 million.
They spent this money the very next day. This is a zero coupon bond so
Michigan doesn’t have to pay a penny until the maturity. The maturity was FIFTY YEARS!!!! The principal due at maturity? An unbelievable $4.4 BILLION. And there is not sufficient revenue to cover it. Note: This piece of crap is in pension fund hands. Talk about kicking a can down the road.


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downrodeo's picture

101 reasons to quit smoking now.

Thanks Bruce, for all of your hard work. The snake is eating his tail, and he's almost reached the neck, it would seem.

Bubbles's picture

So what is the expectation for inflation between 2008 and 2058?  Maybe Michigan got a great deal on the 50 year zero coupon bond. 

Bruce Krasting's picture

If inflation tops 8.875% we are dead. We will never make it to 2058.

Whatta's picture

Time for states to revisit the tobacco suit and find some legal maneuver to reopen and dig a little deeper into Big Smokies pocket....the American Way.

Joe Davola's picture

Most likely tobacco road probably has a new strategy all ready and just waiting to run rings around the AG's yet again.

SwingForce's picture

Yes they do, its called split off non-US operations, and all other non-tobacco business. That's why you now have Philip Morris Intl. and Kraft Foods trading as stand-alone entities. Never forget that the tobacco industry has the smartest lawyers on the planet. 

bank guy in Brussels's picture

Here in Belgium there is lots of semi-anarchist smoking in the local cafés, Belgians being a wonderfully rebellious sort.

And those of us a little older, remember just how great tobacco advertising was ...

Here's a real classic ... short video of the wonderfully hilarious, and sometimes sexy, Benson & Hedges advertisements, people constantly getting their long '100s' cigarettes crushed by accident because they weren't used to the extra-king-size, like when ogling a girl in a mini-skirt.

The music here became a big hit, performed by 'The Brass Ring', the song called 'The Dis-Advantages of You' (1967) - great audio on this clip here, too.

We over-50 people will all recognise the tune instantly tho we may not have known the name ... Quite a nostalgia trip ... and in fact makes me want to light one up with the other rebellious Belgians in the cafés here. I might just do that right now ...

'Relax and enjoy ...'

chunkylover42's picture


Why would a tax-exempt bond such as the Michigan one you cited be in a pension fund?  DB plans are already tax-exempt entities so they don't benefit from the bond's T/E status and they would collect a shit yield (1.32% at issue) in the process.

The muni market is a retail market, so th4e bond is probably in some poor sap's Citigroup brokerage account because his idiot broker had to unload some inventory.

Bruce Krasting's picture

Look at the description again. The Price is 1.32 the Yield is 8.87%.

I think the paper is in pension funds because of the high yield. This rate is above the 8% hurdle rate for most DBs. There is also the duration. This (on paper) adds to the average life of the total portfolio. So it fits, the tax exempt feature is a throw away, in my opinion.



SmittyinLA's picture

50 years from now a soylent green taco with a side of Soma salsa will cost you $5 billion.

b_thunder's picture

1. the bond issuers rightly figured out that they won't be around when $4.4B comes due. for now they get their promotion or move on to the private sector

2. the bond buyers - well, the actual physicel human beings that signed on the dotted line - they get their bonus and move on to other firms

3. if we do have annnual double-digit inflation over next 5-10 years, this bond will be the best thing ever for the issuers.


earnyermoney's picture

True irony if the Pension fund holding this is none other than GM's UAW.

Broomer's picture

Now the question is, will 4.4 billion be enough to make even with 50 years of inflation?

SwingForce's picture

Wow, this one's a beauty- this is the opaque-ness MWhitney talks about. Michigan is screwed. BTW- What's the current bid on those zeros?

AR15AU's picture

Back in 2008 the State of Michigan borrowed $58 million. They spent this money the very next day. This is a zero coupon bond so Michigan doesn’t have to pay a penny until the maturity. The maturity was FIFTY YEARS!!!! The principal due at maturity? An unbelievable $4.4 BILLION. 

Slavery: alive and well in Michigan...

DoChenRollingBearing's picture

I see fewer and fewer investment options that are any good.  I guess buying gold looks to me to be best.

THANKS Bruce for the interesting post on a topic I knew very little about.

And look at how, once again, how the state .govs have been thinking short term only.  Kick that can!

trav7777's picture

this paper shit was never really an "investment."

Gold isn't either, but at least it holds value.  WTF in paper is any good anymore?  I guess the defensive plays still pay meager dividends.

When this shit all blows, up people will get those high yields they want

wombats's picture

Thanks for this article.  I never realized that this was going on.  I think you're definitely right about this being a great example of kicking the can down the road.

piceridu's picture

BK, I'll say it again. We are lucky to have you post on this site. I for one would have never seen or heard of this without you taking the time to post. Thanks as always...another homerun.

nevadan's picture

I hear Ted Bundy finally quit smoking.