November 15, 2018

Muni Update: Where’s the Mint?

by Refinitiv.

The Impact of the Proposed Menthol Ban on Municipal Tobacco Bonds

In the 1920s, a person named Lloyd “Spud” Hughes came up with a novel idea of adding menthol flavoring to cigarettes in order to give the illusion of a “cooler” smoke. This would spur the development of the menthol cigarette in the United States. Over the years, it would become the mainstay for a large portion of the smoking population. The era on menthol cigarettes, however, could be coming to an end.

Last Friday the Wall Street Journal reported that the US Food and Drug Administration (FDA) was pursuing a complete ban on the sale of menthol cigarettes. Since then, the FDA has provided some additional details regarding the proposed ban. The article notes that any complete ban may take a couple years before it is finalized and enforced. Furthermore, the major tobacco companies may file a lawsuit in order to block any ban.

Tighter regulation on sales of menthol cigarettes should not come as much surprise. A FDA study done in 2013 concluded that menthols posed a greater health risk versus regular cigarettes, and were associated with increased smoking initiation by youth and young adults. The announcement of a complete ban did, however, come as a surprise to the market as nearly half of the estimated 38 million American adult cigarette smokers smoke menthols (Source FDA).

Along with the ban on traditional menthol cigarettes, the FDA also proposed a ban on the sale of fruit flavored e-cigarettes at all brick-and-mortar stores due to their popularity among youth. Tobacco, mint, and menthol flavored e-cigarettes are not included in the ban. Needless to say, the headwinds for the tobacco sector are growing.

For the municipal market, a ban on menthol cigarette sales will pose an additional risk to bonds backed by tobacco securitization payments. These annual payments can be adjusted downward if cigarette consumption declines faster than expected (among other factors). A short-term boost in cigarette consumption may occur as menthol smokers start hoarding, but in the long run a ban should put further pressure on tobacco consumption. This would only serve to exacerbate the downward trend we have seen over the past four decades. More recently, cigarette sales declined by 4.4% in 2017 with the smoking rate reaching an all-time low of 14%.

Tobacco bonds have traded sharply lower on this recent news. For example, Ohio Buckeye Tobacco Settlement bonds with a 5.875% coupon maturing in 2047 traded on Tuesday with credit spreads 20bps wider compared to the previous week. Prior to the news, the tobacco sector had performed well year-to-date, driven primarily by expectations for previously issued debt to be refunded at lower yields and higher prices. With any menthol ban, assumptions for future cigarette consumption will need to be shifted downward. This would make the economics of any tobacco securitization transaction less appealing, potentially derailing any refinancing all together.

Source: Thomson Reuters Pricing Service. Spread is to the AAA municipal benchmark.

A complete menthol ban may take a couple years to be fully implemented, and current menthol smokers could transition over to other forms of smoking. A key question is whether current menthol smokers will transition over to traditional cigarettes, which would cushion some of the blow to tobacco bond cash flows. On the other hand, if a greater percentage switch over to e-cigarettes, or quit smoking all together, the market could see sharper declines in payments securitizing outstanding tobacco bonds. Despite the recent volatility, it is yet to be seen how these bans will impact tobacco bonds over the long term.

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