COHICK: Needless to say, a lot going on. Are there other market dynamics that might be positive or negative for the asset class?
COLBY: Well, in high yield especially, there’s one particular feature that is worth paying attention to, that probably will be pervasive through the rest of 2018, and that is refinancing that have occurred in the tobacco securitization sector.
Already we’ve seen some $3 billion of tobacco bonds taken out of the high yield portfolios by a refinancing, which has had the impact of raising the prices of the remaining securities in the high yield space, which actually accounts for the strong performance in high yield on a relative basis.
What are tobacco bonds?
Tobacco bonds are one of the largest, most liquid, and highest yielding segments in the municipal bond space (HYD) (ITM) (SMB). A tobacco bond, a unique asset class, is secured by a claim of a perpetual stream of annual payments. These payments are owed from US tobacco manufacturers to US States and are sensitive to future cigarette consumption.
In 2017, tobacco bonds gained 22%[1.Bloomberg Barclays High Yield Tobacco Muni Total Return Index, return of 22% as of Dec 31, 2017]. As the graph above shows, tobacco muni bonds have outperformed all other revenue sectors of the US municipal market. Since 2010, tobacco muni bonds have outpaced the muni bond market and the high yield muni bond market.
In April 2018, the governor of New Jersey, Phil Murphy, announced a creative refinancing issue involving revenue from the tobacco industry. Reuters reported that under this deal, New Jersey would be selling $3.2 billion of tobacco refunding bonds, which will upgrade its rating from junk status to investment grade. It’s expected that this refinancing deal could yield around $250 million in immediate savings under today’s bond market conditions.
Tobacco bonds in general offer relatively good cash flow return compared to corporate bonds even in downside scenarios. These bonds are structured as asset-backed securities with various tranches wherein investors can choose to invest in a particular tranche depending on appetite for risk. Investors should also keep in mind that tobacco bonds are susceptible to interest rate changes.