What is Driving the TSSB Market?
At first blush, healthier tobacco companies might appear to be good news for TSSBs. However, thanks to the way the MSA is structured, this line of thinking is misleading at best. Tobacco industry payments into the MSA fund are calculated based on a number of factors, including inflation and non-participating manufacturers’ market share. Crucially (and unfortunately for TSSB bondholders), settlement payments are calculated not from revenue, but from the actual number of cigarettes shipped, which has been steadily declining by about 3.33% annually since it peaked in 1981. For example, if tobacco companies hypothetically raised cigarette prices by 5%, causing volumes to fall by 3%, tobacco companies might see higher profits, but the MSA would receive lower payments as shipments declined. Moreover, MSA payments do not include the proceeds from non-cigarette revenue or shipments: cigars, pipe tobacco, smokeless tobacco, nicotine gum, electronic cigarettes, and other “vaping” products are all excluded from the calculations.
When it comes to the TSSBs themselves, they have a more complex structure than typical municipal bonds. Because payments are pledged in perpetuity, if a tobacco bond defaults (i.e., fails to pay all interest and principal due), it doesn’t necessarily mean that bondholders won’t get paid, it just may be on a much longer payment schedule.
The most important factor that’s impacting settlement payments under the MSA is US cigarette consumption. People don’t smoke that much anymore. If more people keep smoking, there’s a better chance that tobacco bonds (HYD) will avoid default.
However, as the above graph shows, annual cigarette consumption in the US has fallen over the last three decades. Cigarette consumption has fallen 50% in the last three decades, as the graph suggests. Lower consumption had a negative impact on MSA payments, as we explained in the previous part.
If cigarette consumption keeps falling, which seems to be the trend, MSA payments might continue to decline. Tobacco bonds would be in a technical default, as we’ll discuss later in the series.