Cigarettes come with warning labels. Tobacco bonds should, too. These securities are highly volatile, and at current prices they have nowhere to go but down. There are healthier alternatives in the high-yield municipal bond market.
Tobacco bonds grew out of a landmark settlement with tobacco companies that awarded states billions of dollars a year, in perpetuity, in compensation for the healthcare costs of smoking. Many states decided to securitize their share of the payments by issuing bonds backed by the settlement revenue. This provided them with money up front for their immediate budget needs, which they would repay with interest to bondholders over time.
Over the years, tobacco bonds have become an important part of many municipal bond strategies. They account for nearly a quarter of the high-yield muni market, and over the past three years, they have outperformed stocks by 3% annualized. That’s largely because of high investor demand for a liquid sector in a market where supply has been limited.
But tobacco bonds are nearly as volatile as the equity market, and almost twice as volatile as the rest of the high-yield muni market. They’re also expensive. Three years ago, prices were practically at fire-sale levels, as the following Display illustrates. Today, they’re approaching par. At these prices, we doubt that investors are being adequately compensated for their risk.
Cigarettes: Hazardous to Your Health and Your Portfolio
What makes tobacco bonds risky? Simply this: their payments are based on cigarette consumption. Anything that affects demand for cigarettes and cigarette shipments—for better or for worse—affects the pricing of tobacco bonds.
That’s worth thinking about, because federal, state and local governments have been working hard for years to discourage smoking by proposing nicotine limits in cigarettes, higher tobacco taxes, regulations on indoor smoking and other measures. The result: smoking has been on the decline for decades—a trend that’s likely to continue. Altria’s third-quarter earnings showed that sales of its flagship Marlboro cigarettes were down 3.9% this year through September and 6.2% in the third quarter alone. California’s recently adopted $2-per-pack cigarette tax may have contributed to the quarterly sales decline.