Despite recent spread-widening and underperformance by the tobacco bond sector due to falling cigarette sales and tobacco usage, it has been supported by solid demand for high-yield paper and strong technicals behind it.
Good demand for tobacco bonds accounts for the small spread widening and underperformance, said John Miller, head and chief investment officer of First Eagle’s High Yield Municipal Credit team.
For the latter, the “recent underperformance may have provided investors with a decent entry point,” said Vikram Rai, head of municipal markets strategy at Wells Fargo.
High-yield tobacco “returns underperformed the broader [investment grade] and HY markets year-to-date even though they outperformed most HY sectors last year,” he said.
High-yield bond spreads have been impacted by about 30 basis points to 55 basis points, and “this has shaken tobacco spreads off of the lows that had matched pre-pandemic levels,” Rai said.
For the four weeks ending April 20, cigarette volumes were down 9.9% year-over-over, according to MSA, and down 10.6%, according to Nielsen.
With the market “hungry” for high-yield bonds, the declining cigarette sales have not had as much of an impact “as maybe it should or could in the future,” Miller said.
Rai agreed, noting that “yield-hungry investors may find current levels and spreads compelling in light of the upcoming summer technicals.”
Rai, though, noted there is a “sustained overhang of declines in cigarette shipments and the regulatory risks on the horizon.”
For decades, the percentage of smokers has been “falling roughly in a straight line” in the U.S. and the U.K., among other countries, he said.
“Logically, if the prevalence continued to fall in a straight line, it would hit zero sometime around 2050, meaning there would be no more smokers in those markets,” Rai said.
There are positives for the sector — such as the delayed issuance banning the sale of menthol cigarettes — but “owing to its ‘sin’ status, has persistent regulatory risk,” Rai said.
Other headwinds exist, such as “refinancings have made the sector less attractive, and ESG-focused clients are likely to shun this sector,” Rai said.
Miller noted the changes in nicotine use, such as vaping and smokeless tobacco, two alternatives promoted by manufacturers, can be an issue, along with “faster-than-expected declines in tobacco consumption,” according to J.P. Morgan strategists.
Furthermore, there is also pressure from prices in an inflationary environment and cheaper generic cigarettes, Miller said.
Anticipation of lower cigarette sales can potentially affect tobacco company margins, thereby creating concerns over predetermined payments, as determined by the Master Settlement Agreement, to pay tobacco debt service.
MSA payment data released at the end of April showed payments across all states fell 9% compared to 2023, while the payment to Ohio dropped by 28%, J.P. Morgan strategists said.
The MSA reached a deal in November 1998 where the Office of Personnel Management had to “pay, in perpetuity, annual payments to the states to compensate them for the medical costs associated with smoking-related illnesses,” Rai noted.
These payments “have been underwhelming for some of the states with the largest and most active tobacco bonds, and these bonds have underperformed even more as a result,” Barclays strategists said.
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“Following the data release, in limited trading, secondary spread changes on Buckeyes varied by security,” J.P. Morgan strategists said.
For example, the A-rated Buckeye 4s 2039 widened by four basis points in trading on May 1 but tightened by only six basis points in trading on May 8, whereas BBB-rated Buckeye 4s 2048 spreads widened by nine basis points following the release of the MSA payment data, they said.
Buckeye 5s of 2055 — ”most liquid HY tobacco bond and the bellwether for the entire HY tobacco sector” — saw trading activity pick up following the MSA data release, with the spread widening from 155 basis points to 179 basis points as of Thursday, according to J.P. Morgan strategists.
The payment sales were a “huge miss” relative to how these bonds are structured, Miller said.
While it’s not a good fundamental sign, bonds like that in general are “doing OK” due to technicals, he said.
“The municipal market is influenced more by technicals than they are by fundamental factors, and this is especially true of the tobacco sector,” Rai said.
The high-yield tobacco sector’s performance depends on the high-yield fund flows, he noted.
There have been three weeks of inflows into muni mutual funds and high-yield funds, which continue to support sector valuations, J.P. Morgan strategists.
Muni mutual funds saw inflows of $1.053 billion for the week ending Wednesday, the first time since January that inflows have topped $1 billion, while high-yield funds saw inflows of $391.9 million, according to LSEG Lipper.
Following the recent Federal Open Market Committee meeting “rates are more likely to rally between now and year end which should lead to healthy inflows into HY municipal mutual funds,” further supporting tobacco performance, Rai said.