Citi Global Multi-Research analysts Vikram Rai and Mikhail Foux analyze the opportunity presented by beaten down tobacco bonds in their research paper “US Municipal Strategy Notes – Time to Take up Tobacco” of October 23.
Munis and Tobacco Bonds – Overall Scenario
Municipal bonds overall were not spared the carnage in fixed income following the debt ceiling crisis as well as sector specific headaches such as credit apprehensions, unrelenting mutual fund outflows and negative media publicity.
Within this space, tobacco bonds faced additional punishments at the hands of investors due to default fears arising from declining consumption/shipments and the increasing adoption of e-cigarettes. In addition, pending litigation cast another pall of uncertainty over these bonds.
This overall doom-and-gloom scenario reflected in Muni/tobacco yields and is well-captured in this chart:
Tobacco – Silver Linings
– Arbitration ruling on September 11, 2013, removed some litigation overhang from tobacco because of the additional cash (10-12%) that would be available to certain states from MSA. It also offered the prospect of similar rulings down the line. The additional cash would serve as a buffer against declining payments due to the industry woes.
– The ruling caused a temporary bump (~80bp) in the tobacco bonds that investors quickly sold into, with the result that net-net these bonds were cheaper by ~60-70 bp.
– Yet, an IRR analysis by Citi, including worst-case shipment declines of CAGR 7%, reveals that these bonds offer returns over 5% as shown in the table below:
– Investors may be overly pessimistic over the cigarette industry. Citi points out that declines of ~7% are hardly likely to happen given that e-cigarettes face several regulatory hurdles that could crimp their demand growth.
– Investors may be ignoring these positive factors, and thereby turning away a value opportunity.
Tobaccos are cheap compared to long B corporates on a relative value basis. This acquires significance given the low supply of high yield paper from Muni issuers, adding to the scarcity appeal of tobaccos, which are attractive also for their high liquidity. Tobacco bonds are recommended for investors looking for higher coupon yields for longer durations.