As cigarette sales decline and tobacco giants lose market share to vaping upstarts, some assumptions underlying tobacco securitization bonds have been upended.
Bloomberg News
Lower than five years after Ohio restructured the credit to avoid a default, the Buckeye Tobacco Settlement Financing Authority needed a debt service reserve draw to pay holders of its tobacco settlement securitization bonds.
The Buckeye authority required a reserve draw to make an $81.6 million interest payment due Dec. 1, in response to a Nov. 22 event notice posted on the Municipal Securities Rulemaking Board’s EMMA website.
The authority was issued the country’s biggest securitization of tobacco settlement revenues in 2007, a part of a wave of deals securitizing payments from the 1998 Master Settlement Agreement during which 4 tobacco giants agreed to settle lawsuits brought by 52 state and territory attorneys general over health care costs from smoking. The agreement was to compensate states for the healthcare costs they incurred treating smokers.
In 2020, with the Buckeye tobacco bonds facing downgrades and the prospect of default, Ohio undertook a $5.35 billion refinancing that re-established among the bonds — which had tumbled into junk territory — as investment grade. The refinancing won The Bond Buyer’s 2020 Midwest Deal of the Yr award.
In November, the Buckeye authority initiated a draw of $10.581 million on the Class 2 Senior Liquidity Reserve Subaccount, which secures only the Series 2020B-1 senior bonds and the Series 2020B-2 senior bonds, in response to the official statement on the Series 2020 refunding bonds.
The remaining balance within the Class 2 reserve account is now $160.268 million; the quantity required to be held within the reserve account is $170.85 million.
On the authority’s Sept. 24 meeting, Assistant Secretary Diane Chime said Ohio received $231.8 million for its 2023 tobacco settlement revenues payment, but a further $92.2 million was held aside by tobacco manufacturers within the disputed payment account, in response to the meeting minutes.
For the primary time since 2020, tobacco settlement revenues and interest earnings on the reserve fund and other pledged accounts fell in need of the quantity needed for debt service.
“That level of withholdings [by the tobacco manufacturers] was higher than lately,” Laura Martine, director of communications for Ohio Treasurer Robert Sprague, told The Bond Buyer.
Martine noted that each one bondholders were paid in full and no event of default occurred as defined within the bond indenture, which excludes reserve draws from its definition of “event of default.”
In its Jan. 8 default trends report, Municipal Market Analytics flagged the performance problems with Ohio’s tobacco bonds, noting that the reserve draw had driven a jump within the state’s impairment rate to eight%.
MMA Partner Matt Fabian said that currently, the tobacco bonds account for about three-quarters of impaired Ohio debt.
“Over the long run, things shift,” he said. “This is precisely the chance states like Ohio transferred to bondholders after they did the securitizations in the primary place; it’s why tobacco bonds exist. Bondholders accepted the long-term timing risk of settlement payments in exchange for receiving a comparatively high rate of interest. State taxpayers received money up front and so didn’t should worry about future cigarette deliveries.”
It has been a bumpy road for the Buckeye authority, and the tobacco bond landscape has modified considerably since its tobacco bonds were first issued.
The MSA required participating manufacturers to pay their relative market share of billions in annual payments to states.
It established a formula that was designed to offset the competitive drawback to participating manufacturers within the settlement of getting to make annual payments to each state.
And it created a disputed payments account, into which contested payments could be put aside pending the resolution of an investigation by an independent auditor.
Not all states are pleased with the outcomes of the MSA. Latest Mexico has since accused the participating manufacturers of lying to the independent auditor and conspiring to postpone payment obligations, amongst other things. Iowa recently alleged that $133 million had been wrongly withheld, in response to Law360.
Between 2000 and 2017, many states selected to securitize their payments under the MSA, with 20 states and territories issuing tobacco bonds during that period.
The state’s General Assembly created the Buckeye authority in June 2007, and that October, the state, as was standard for tobacco securitizations, gave the authority all its rights and interests under the MSA, including Ohio’s share of tobacco settlement revenues until all bonds have been repaid. The authority consists of the governor, the Ohio treasurer and the Office of Budget and Management director.
It was a fertile time for tobacco securitizations. A 2007 response from JP Morgan to the state’s request for proposals that was obtained by ProPublica noted, “The MSA-backed sector has reached a transformative point in its history with record volume, pressure on credit spreads, and up to date wholesale changes to rankings criteria.”
The Buckeye authority picked Bear Stearns and Citi as joint bookrunning senior managers for the 2007 tobacco bond deal.
Fitch rated the 2007 bonds BBB-plus. S&P rated them BBB at time of issuance.
Ohio’s 2017 $5.5 billion securitization was the biggest ever accomplished, Joshua Cain wrote in a 2017 paper for the Glucksman Institute for Research in Securities Markets at Latest York University. Like many other states, Ohio didn’t use the cash to fund smoking prevention programming.
And like California’s Golden State Tobacco Securitization Corp., whose securitization approach it matched, Ohio’s authority opted for an aggressive structure with a high sensitivity to drops in available revenue. Ohio’s 2007 A-2 tranche was paid down slower than expected, and the authority had to attract on its reserve fund to make principal and interest payments, Cain noted.
“Since all tobacco settlement securitizations are backed by the identical underlying money flow, differences in structure, mainly people who affect coverage and seniority/payment priority, are the first source of [the] variance in credit quality,” Cain wrote. “Clearly, the relative aggressiveness and complexity of various tobacco bonds has had an actual effect on their economics.”
The Ohio authority’s taxable Series 2020A-1 senior bonds and Series 2020B-1 senior bonds — and the tax-exempt Series 2020A-2 senior bonds, Series 2020B-2 senior bonds and Series 2020B-3 senior bonds — are a mixture of current interest and capital appreciation bonds.
The official statement for the Series 2020 bonds incorporates a section on bond structuring assumptions. They include “that there will likely be no adjustments to the annual payments resulting from miscalculated or disputed payments.”
Other assumptions were that participating tobacco manufacturers would make all payments required of them by the MSA; that the combination market share of the unique 4 tobacco giants would remain constant throughout the forecast period at its 2018 level; and that the combination market share of newer participating manufacturers would also remain constant at its 2018 level.
Martine, the treasurer’s spokesperson, said the Series 2020 bonds “are structured to face up to year-over-year [tobacco] consumption decline,” and the senior liquidity reserve accounts offer additional bondholder security within the event that pledged tobacco receipts underperform estimates.
Jie Liang, sector lead for S&P Global Rankings structured finance rankings, noted that S&P’s criteria include a set of stress runs, akin to the cigarette volume decline test, the NPM adjustment stress test and the PM bankruptcy test.
S&P’s base case assumption for 2023 consumption decline was 4.00% to 4.50%. The actual consumption decline for 2023 was around 8.7%, in response to National Association of Attorneys General data.
“We revised our assumptions last week based on long run trends,” Liang said. “We also run additional sensitivity scenarios akin to a one-time steep decline in cigarette consumption to deal with potential shocks to the industry or significant regulatory changes.”
Over the long run, MMA’s Fabian said, “the entire asset class has a payment sufficiency challenge.” As cigarette smoking declines and is eclipsed by vaping, tobacco settlement revenues have not kept up with projections.
“And projects that are not restructured to suit into the most recent version of the money flows may wind up drawing on reserves sooner than the others,” Fabian added.
For the 2020 refunding, S&P assigned rankings between BBB-plus and A to different tranches, leaving the biggest $3.78 billion chunk of the deal unrated.
That rating range still holds.
The rating agency updated its annual cigarette volume decline assumptions last week, and didn’t place Buckeye Tobacco on CreditWatch with negative implications prefer it did another tobacco bonds.
“Our rating rationale is especially based on tobacco consumption, the [participating manufacturer] market share, and the potential impact of industry litigation,” Liang said. “Asset isolation from the municipalities’ general obligations and bankruptcy remoteness of the legal structure typically allow the senior bonds to receive investment-grade rankings, depending on our money flow evaluation of the payment structure.”