Reading the Smoke Signals in the Municipal Markets

While today's bottomed-out interest rates and modest yields aren't ideal conditions for fixed-income investors, the situation has raised the profile of subsectors that were previously considered more niche than core, such as municipal tobacco. The most common index for core municipal bond fund performance is the Barclays Municipal Index, which is limited to investment-grade bonds. In 2015, tobacco was its second-highest performing sector, delivering 3.8% versus the 3.3% return of the overall index. Higher-yielding tobacco bonds had a much better year, however. The S&P Tobacco Index, which includes both investment-grade and high-yield bonds, surged by 13.5% in 2015. During the past decade, the tobacco sector has ranged from an allocation as high as 4.1% of the Barclays Municipal Index (October 2007) to as low as 0.6% (April 2016). While tobacco bonds have fared well recently, this remains a small slice of the muni bond market. Estimates of the tobacco bond market measure it at around $34 billion--a tiny fraction of the $3.7 trillion in outstanding municipal debt.

What Are Tobacco Bonds and Why Are They Risky? In 1998, the surgeon generals of 46 states entered into an agreement with a collection of major tobacco companies titled the Tobacco Master Settlement Agreement. In exchange for limitations on the private liabilities that could be lodged against them, the tobacco companies agreed to provide a perpetual stream of payments to the states for managing smoking-related healthcare costs. Many states chose to borrow against the promised funds and securitized the cash flows into municipal bonds. While bond details vary not only by state but also by security, the Master Settlement Agreement-backed bonds rely heavily on the strength of future cash flows, which are tied to the revenues of tobacco companies. As cigarette consumption diminishes (it has for most of the past decade), so too does the strength of the projected cash flows supporting these securities.

A number of factors light up the sector's risk profile. During the past year, credit spreads have generally been tight, and tobacco bonds propose a yield much higher (though riskier) than other municipal sectors. Fitch Ratings provided an institutional declaration of risk when it announced that it would retract ratings on all tobacco bonds before the end of June 2016, because of deteriorating fundamentals in the subsector. Additionally, with the Puerto Rico default in motion, municipal managers that once relied on the island's debt for return enhancement are left looking for other ways to differentiate their portfolios. Tobacco has been the recipient of some of this interest, and not simply from municipal managers. Hedge funds have traded in the market while prowling for yield, but whether the registered liquidity will persist remains an open question. Perhaps most unexpected is the effect from oil price swings. Since late 2014, the precipitous fall of oil prices has been a plus for cigarette sales: The lower the price of gas and the more miles driven, the greater the disposable income spent on cigarettes. Counter to consumption projections that expected tobacco usage to dip, cigarette sales have fallen only modestly or remained steady in the past year.

What Does This Mean for Municipal Bond Portfolios? Understandably, the sector is a reasonable menu option for high-yield muni portfolios, but many core municipal managers mention that the sector's stellar recent performance in the index makes it difficult to ignore completely. Other core municipal managers consider the performance an aberration and won't hold tobacco bonds based on their lack of strong, longer-term fundamentals.

Of Morningstar Medalist funds in the municipal intermediate- and long-term Morningstar Categories, allocations ranged from 0% to around 4% of the portfolios as of March 31, 2016. Managers with conviction in tobacco bonds describe detailed models for the various cash flow scenarios, and some expect consumption to decrease at a slower rate than projected. Older tobacco issues are frequently and strongly cited as preferable to newer tobacco issues, as the more vintage securities are advantageously structured with first access to available cash flows.

That said, unexpected external factors, such as low gas prices, further contribute to volatility in cigarette sales, leaving the future realizable value from tobacco bonds a question mark. Another key factor to consider is how much liquidity will continue to be provided by nonmunicipal buyers. And yet, with all of these risks, it's important not to get lost in the smoke. Tobacco bonds are a small portion of the fixed-income markets and are modestly held across municipal portfolios. Since January 2010, the maximum allocation to tobacco bonds in the muni long- or intermediate-term categories has been around 11% or less, with the vast majority of funds holding somewhere between 1% and 3%--not enough to wreck a fund, but certainly enough to challenge the portfolio given the many risks associated with tobacco bonds. Investors with keen insight and dedication to meticulous cash flow modeling may yet discover yield through scrutinized analysis, but opportunities may be limited given the bonds' recent outperformance.