Tobacco Bonds Dip, Yields at 6.2% Amid Smoking Decline

Key Takeaway

• Tobacco bonds became the worst performers in high-yield municipal debt due to a decline in smoking, with a 0.4% drop year-to-date.
• US states received $5.8 billion from tobacco companies, the lowest since 1999, impacting bond payments.
• Speculative-rated tobacco debt yields rose to 6.2%, offering potential for recovery amid scarcity and investor yield search.

Tobacco Bonds Falter Amid Declining Smoking Rates

Tobacco bonds have emerged as the weakest link in the high-yield municipal debt market, with a 0.4% drop in the year to May 7, starkly contrasting with a 2.3% gain across the broader high-yield tax-exempt market. This downturn is attributed to a significant decline in smoking rates, which has, in turn, reduced the payments backing these securities to a record low. The United States has seen its adult smoking population decrease from 21% in 2005 to almost 12%, according to government data. This year, US states are set to receive $5.8 billion from tobacco companies, marking the smallest payout since the inception of payments from their legal settlement in 1999.

Market Reaction and Recovery Potential

The announcement of this year's reduced settlement payments caught investors off guard, leading to a knee-jerk reaction that contributed to the bonds' underperformance. However, Eric Kazatsky, a strategist at Bloomberg Intelligence, suggests there's room for recovery. With the ongoing hunt for yield in the financial markets, any opportunity to capture additional spread is valuable. Speculative-rated tobacco debt now yields 6.2%, surpassing the broader high-yield index's 5.5% yield. Despite the current downturn, these bonds offered a 12% return in 2023, buoyed by the stable settlement agreement between states and manufacturers.

Scarcity and Regulatory Decisions Influence

The tobacco bond market's dynamics are also being reshaped by a decrease in available securities, driven by a wave of refinancings that have led to upgrades to investment grade for some bonds, thus removing them from the high-yield index. The share of tobacco debt in the high-yield gauge has diminished to 6.1% from 15% in 2019. Additionally, the Biden administration's recent decision to delay a potential ban on menthol cigarettes has been seen as a positive development for the sector, according to Barclays analysts Mikhail Foux and Clare Pickering. This regulatory reprieve could offer some support to the beleaguered bonds.

Street Views

• Eric Kazatsky, Bloomberg Intelligence (Neutral on tobacco bonds):

  "It’s almost like there was a knee-jerk reaction... with everybody scrounging for yield, any little bit of incremental spread is helpful."

• Mikhail Foux and Clare Pickering, Barclays (Cautiously Optimistic on tobacco bonds):

  "This complex has started to look more interesting, but with its levels well below the highs of last October, we might see further weakening in the near term."