Coughing All the Way to the Bank

After hitting the jackpot in 1998, an increasing number of the 46 states that won a total of $206 billion in a settlement with tobacco companies want to receive their money in one lump sum. To do that, Alaska, Alabama, Iowa, South Carolina and Louisiana are backing a new kind of municipal bond called tobacco bonds with their portions of the settlement.

Tobacco bonds are backed by settlement payments that the tobacco companies will make over the next 25 years. In Louisiana's case, the state took 60% of its rights to a $3.8 billion dollar settlement and sold it to Bear Stearns, which in turn created bonds and brought them to market. The whole process, called securitization, was completed on Oct. 30, and more than 170 buyers, mostly large institutions, snapped up the bonds.

Municipal bond experts, however, warn that tobacco bonds are not the best investment for individual investors. "First, it takes time to understand the legal framework that provides the security for these bonds," says Cadmus Hicks, vice president of investment strategies with Nuveen Investments, an investment management firm with $66 billion in assets under management and a large buyer of Louisiana's tobacco bonds. Individual investors also need to understand how the bond payment schedule depends on tobacco revenues. The rate at which the bonds are repaid is based on the rate of revenue received by the state, and that is tied to cigarette sales.

To make matters worse, retail investors swimming in institutional waters often get a raw deal from bond dealers, who frequently mark up bonds to ensure a bigger profit, says John Fox, a senior vice president with Gannett, Welsh & Kotler Capital Management, which has $5 billion in assets under management. As a result, potential individual investors will need deep pockets to dabble in tobacco bonds.

Smoke 'Em If You Got 'Em

But while these bonds aren't necessarily right for the individual, they're appealing to institutions. The bonds offer attractive returns and a unique way to diversify portfolios. "You can pick up around 1% -- 100 basis points -- over AAA rated municipal bonds of like maturity," Fox says.

Most of the tobacco bonds have an A rating, the third-highest rating, which puts them in the category of upper-medium-grade investments. Moody's bond ratings vary the most, with Alabama's bonds rated Aa1, a lower high-grade bond, while some county bonds are rated Baa2, an ordinary medium-grade bond.

Now that the Federal Reserve has eliminated the 30-year bond, the tobacco bond may look like a long-term alternative, because it can take as long as 25 years to fully mature. Such a maturity term could make the bonds more attractive for some, but Fox says it shouldn't be a major reason to buy them.

Up in Smoke?

Even though tobacco bonds offer diversification, attractive returns and a certain amount of security, they are hardly risk-free. Remember, the bonds are backed by the settlement between tobacco companies and certain states, which means that ultimately, bondholders are betting that tobacco companies will be able to pay off the $206 billion over the next 25 years.

If the number of smokers in the United States drops dramatically in the next quarter century, tobacco companies could have a hard time making the payments, because they are tied to sales. And if tobacco companies go out of business, then the bondholders are out of luck. In other words, Louisiana doesn't have to continue payments to shareholders if settlement money dries up.

Many of the bond issues include a study by DRI-WEFA, an economic and financial data provider that examines historical patterns of smoking. In the 1980s, smoking fell by 2.2% a year, while from 1990 to 1998, smoking declined by 1.5% a year. The study says that smoking should decline by 1.8% annually over the next 30 years.

So, could tobacco bonds default? It's unlikely, says Hicks. "All the issues that we have seen have been able to tolerate declines in excess of 3% per year." But the projections for tobacco sales could be way off if older smokers die faster than teens adopt the habit. The risk may not seem great now, but 25 years is a long time.

Further complicating the issue is a possible increase in the supply of tobacco bonds. Many other states, including Wisconsin, Nevada and West Virginia, are considering issuing bonds. With states like New Jersey facing budget crunches, tobacco bonds are a way of using a long-term bond to stave off a near-term crisis. In total, 17 states have either issued tobacco bonds or are considering the option.

"It's premature to step too aggressively into the market now," Fox says. "I would wait a few months to see how the market digests the coming supply, and take advantage of any backup in prices."

The Last Puff

But for now, institutions are snapping up the tobacco bonds. The recent Louisiana offering closed a mere $3.6 million less than projected, an insignificant margin considering it raised $1.2 billion total. "We find that these bonds can offer good value for the level of risk involved," Hicks says.