California, Ohio Use Reserves for Tobacco Bonds

California, Ohio and Virginia will use reserve funds to pay interest and principal on bonds backed by tobacco company payments under a 1998 health-care settlement, according to a report by Herbert J. Sims & Co.

Payments to the states by Altria Group Inc. (MO)’s Philip Morris unit, Reynolds American Inc. (RAI) and other companies have declined on lower U.S. cigarette sales and as the companies lose market share to tobacco manufacturers that didn’t participate in the settlement, according to Richard Larkin, director of credit analysis at Sims in Iselin, New Jersey.

“Any time you see a municipal bond go to their reserve fund, it’s a significant sign of trouble,” Larkin said in a telephone interview. “It’s not an imminent default, but it’s a sign that cash flow is certainly far weaker than any of us thought.”

U.S. states have more than $107.6 billion in outstanding bonds backed by the 1998 settlement, according to data compiled by Bloomberg. Under the settlement, tobacco companies agreed to reimburse states $246 billion for treating smoking-related illnesses. The companies make annual payments each April.

The amounts paid to the states declined 5.6 percent this year, mostly because Altria’s Philip Morris decided for the first time to withhold disputed payments, Larkin said, citing data from the National Association of Attorneys General. In 2010, the payments fell 16 percent after the federal government raised cigarette excise taxes 61 cents.

Payments in Escrow

Since 2005, Reynolds and Lorillard Inc. (LO) have put a portion of their payments into an escrow fund, arguing that they’re entitled to refunds because they’ve lost market share to other producers such as National Tobacco Co. LP, which didn’t sign the 1998 accord.

Philip Morris made its full payments to the states, even though the tobacco company disputed them, until this year, when it withheld $267 million, Larkin said. Philip Morris disclosed the escrow payment in an April 15 statement.

California’s Golden State Tobacco Securitization Corp. and Ohio’s Buckeye Tobacco Settlement Financing Authority may use debt-service reserves to meet the minimum required interest payments on Dec. 1, according to bond filings.

The Virginia Tobacco Settlement Financing Corp. will need to use debt reserve funds for its Dec. 1 payment, he said.

Issuers such as Golden State are special entities set up to sell debt backed by the tobacco-settlement money. The states don’t guarantee interest and principal payments on the bonds.

California Reserve Plan

California plans to draw $5.35 million from reserves to help make a $68.3 million interest payment on series 2005 bonds and $7.7 million to make a $87.9 million interest payment of series 2007 bonds, both due Dec. 1, said Tom Dresslar, a spokesman for Treasurer Bill Lockyer.

“Like any other issuer, the state doesn’t relish, to say the least, being forced to draw on reserves,” Dresslar said. “Hopefully, we won’t have to be in that position again.”

Kurt Kauffman, Ohio’s debt manager, said his state expects to use $6 million to $8 million in reserves in December, based on current projections.

“We have a $389 million funded reserve so that offers a significant degree of protection to investors,” Kauffman said in a telephone interview.

Virginia’s director of debt management, Evelyn Whitley, said her state will draw $3.6 million from reserves to make a Dec. 1 interest payment.

“I don’t think it should come as any great surprise,” Whitley said. The state filed a notice when it didn’t make sinking-fund payments last year, she said, and investors “realized it was cutting it close then.”

Lower Investment Returns

Besides payment declines, California and Virginia also received lower-than-expected investment returns on their debt- service reserves, Larkin said. Both states put the money in investment contracts with Lehman Brothers Holdings Inc. (LEHMQ), which filed for bankruptcy in 2008, he said.

While it’s unlikely that more Americans will take up smoking, the outlook for tobacco bonds may improve if U.S. states win a legal challenge to the companies that are withholding payments, Larkin said. About $2 billion held in escrow would go to the states, he said.

“That boost in cash flow would be significant,” Larkin said. “If the states lose, it will look a lot worse.”