Monday, August 6, 2012

>Sustained Decline in Cigarette Consumption Rates Will Cause Many Tobacco Settlement Bonds to Default

Declining rates of cigarette consumption in the US pose a major credit risk to tobacco settlement bonds. In this report we present consumption break-even decline rates that quantify this risk. Consumption break-evens estimate the rate of decline in cigarette consumption that would lead to default for each tobacco settlement bond we rate. The break-even cigarette consumption decline rates for each rated bond also show that under our projection of an annual decline rate range of 3%-4%,1 bonds constituting 74% of the aggregate outstanding balance of all tobacco bonds we rate will default.2 This finding is consistent with the bonds’ current ratings, 79% of which are B1 or lower. The factors leading to low break-even rates are high leverage ratios, long bond maturity, and low cash reserves.

Break-even analysis determines maximum consumption decline before a bond suffers payment default We calculated the break-evens for cigarette consumption decline rates by conducting iterative cash flow analyses to determine the default threshold for each rated bond, holding all other inputs constant. The default threshold is the highest constant annual decline rate for cigarette consumption at which each bond fully amortizes by its final maturity date without a payment default.

As illustrated in Chart I, our break-even analysis finds that 15 tranches representing 33% of the rated bond balance have a consumption break-even of 2%-3%, while 25 tranches representing 41% of the aggregate rated bond balance have a consumption break-even annual decline rate in the range of 3% to 4%. All of these bonds would default if the average annual consumption decline occurs at the high end of that range. This analysis assumes a constant rate of decline for the duration of the bonds’ life.

To read report in detail: CIGARETTE CONSUMPTION