These annual payments, which were agreed prior to the rise in electronic cigarette sales, are directly based upon tobacco cigarette sales in the US. As you can imagine, while sales of tobacco cigarettes have reduced by an average of 3.4% per annum since 2000, many experts believe this rate could increase to around 7% in the medium term. So where does this leave tobacco bonds?
State authorities dipping into financial reserves
When the 1998 arrangement was signed many US authorities went to the financial markets to create so-called "tobacco bonds" which were backed by the income from the agreement with tobacco companies. This allowed state authorities to receive the bulk of future payments upfront, by effectively selling IOUs to investors, using the annual payments to cover interest and eventual redemption payments.
The problem is that when the bonds were created they were structured in such a way as to support a reduction in tobacco sales of between 2% and 3% per annum. The average reduction in tobacco cigarette sales has averaged 3.4% since 2000 and this figure is expected to rise in the short to medium term. How will this impact tobacco bonds and US state authorities?
It has already been revealed that some US states have been forced to dip into their financial reserves to cover the shortfall between US tobacco company payments and interest due on the tobacco bonds. This situation is likely to worsen in the short to medium term and indeed we also have the issue of redeeming these bonds in the future. It may well be that US states will issue further "traditional" bonds to raise funds to redeem the original tobacco bonds but how will this impact upon state authority investment grades?
It will be interesting to see how this particular situation pans out because it is something which has remained under the radar for some time. Many believe that political attempts to bring electronic cigarettes under the guise of tobacco regulations would by default include electronic cigarette sales within the 1998 agreement. Any boost to compensation payments would obviously reduce financial stress on state authorities and lead to a net increase in state spending.
The issue of tobacco bonds has not been discussed at great length over the last few years despite the fact that the rate of decline in tobacco cigarette sales is already outside of the 2% to 3% safety net. It will be interesting to see how the political arena reacts in the short to medium term and indeed whether state authorities are able to bring electronic cigarettes under the guise of tobacco regulations and therefore possibly attempt to include electronic cigarette sales in the 1998 arrangement?