Tobacco Bonds are a huge source of cash flow for a handful of US states but now they are predicted to begin to blemish within the next decade. New data shows that timeline could have decreased to around 5 years.
Some experts say it could be even sooner if the steady decline continues.
So, what are Tobacco Bonds and how is the vaping industry impacting them?
Tobacco Bonds and the Master Settlement Agreement
In November 1998 , some states opted to relinquished all future legal claims against tobacco manufacturing companies for the recovery of tobacco related health care costs.
In return Participating Manufacturers or PM’s agreed to make annual payments with no fixed maturity date.
PM’s also agreed to several marketing restrictions, and to also fund anti-smoking campaigns.
This agreement is known as the MSA.
How Do Tobacco Bonds Work?
States are not restricted on how they choose to spend the money acquired from MSA payments.
However, according to a study done from 2000-2001 by the United States General Accounting Office or GOA , 41% of the MSA payments were allocated to health related programs.
This diagram shows the state allocations of MSA payments (State Fiscal Years 2000 and 2001)
California and New York are the two states with the highest percentage cut of MSA payments coming in at around 12% for each state.
Ohio and Pennsylvania are the next highest coming in at around 5% each.
Payments are made every April 15th of ever year.
The MSA agreement hold PM’s responsible for $206 billion US dollars over the first 25 years.
Of the 50 states in the United States 46 are included in the MSA.
The other 4, Florida, Minnesota, Mississippi, and Texas, had reached agreements with tobacco companies before the November 1998 date.
PM’s reserve the right to withhold a certain percentage of the total MSA payment if they suffered a market share loss due to the adoption of the MSA.
Since 2003 this formula has averaged 12.5% of the total MSA Payment.
This is what can have an impact on the overall cash flow and return projections.
Tobacco Bonds Base Payment Factors
2) Most importantly, National Tobacco Consumption.
That percentage is slowly growing as more users switch from cigarettes, roll your own tobacco, and cigars to electronic cigarettes.
In a previous post we talked a little about tobacco companies and their falling stock prices. These two falling statistics correlate with each other in monumental ways.
Non Participating Manufacturers or NPM’s
Under the MSA, Settling States are required to,
A) Levy a tax on the NPM’s to offset any potential cost advantage NPM’s may gain as a result of the PM’s MSA obligations.
B) Diligently enforce said statute.
But, what are NPM’s and why do they matter? NPM’s are Non Participating Manufacturers and settling states tax these NPM’s because if they did not, the obligations PM’s have towards the MSA would put PM’s at a strong disadvantage.
If settling states did not tax NPM’s, the market would soon dwindle out PM’s. The taxes placed by settling states effectively levels the playing field.
Why Are Tobacco Bonds Diminishing?
Now that we know more about tobacco bonds and how they work, we can look further into why they seem to be failing.
As mentioned before, Tobacco Bonds draw their money from PM’s. These PM’s make an annual payment to the Settling States.
Since the PM’s have the right to withhold a calculated percentage of the annual MSA payment, settling states have opened themselves up to an unexpected variable, vaping.
If you are looking to make the switch to vaping check out our post to help you choose which device is right for you!
Most settling states opted to sell municipal bonds thus securitizing this flow of money, backed by the money expected from the PM’s MSA annual payments.
Since the PM’s MSA payments are based upon tobacco consumption rates, the settling states have seen a decrease in total cash flow from the PM’s.
The dwindling tobacco consumption in forms of cigarettes, roll your own tobacco and others are causing PM’s to withhold more and more from their annual payments.
When PM’s withhold money from the MSA Payments the funds go into a Disputed Payments Account or DPA. The disputed payments will reside in this account until a settlement is reached and agreed upon or until an arbitration board rules on it.
Since 2003 the annual amount withheld from MSA payments have been on average 12.5%. With the amount of OPM shipments decreasing the annual percentage withheld is sure to increase as well.
This leads to settling states missing out on money, thus overtime becoming unable to pay out the municipal bonds.
The US adult cigarette smoking rate from 2005 to 2013 has dropped by 3.1% an continues to fall.
Tobacco Bonds are designed to withstand around a 2-3 percent drop, but if cigarette consumption continues to decrease many financial analysts, including former Eaton Vance portfolio manager Tom Metzold, predict tobacco bonds may perhaps become obsolete within 5 years.
With the growing number of tobacco users making the switch to electronic cigarettes, analysts predict a drop to about 6 to 7 percent may prove fatal and shorten tobacco bonds timeline to a few years.
Bonnie Herzog, financial analysts at Wells Fargo has been keeping a close eye on the tobacco industry for years states “We believe consumption of e-vapor will eclipse consumption of combustible cigs over the next decade as technology improves.” in her most recent report.
Some states like New York and California could see tobacco bonds stifle as tobacco consumption decreases and continues to follow suit and drop annually.
Earlier this month San Fransisco passed a bill to ban all flavored E-Liquid. The California Department of Public Health continues to push for harsh regulations similar to the ban seen in San Fransisco.
New York has a similar bill that has made its way, via a 14-1 vote, to the state senate.