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Just How Crazy Is The Biggest Credit Bubble in History? See The Doomed Muni Tobacco Bonds In Your Conservative Bond Fund

Ah, the spine-tingling pleasures of having this delicious breed of bonds in your conservative-sounding bond fund.

There are $96 billion worth of these municipal tobacco-settlement bonds out there. They’re backed by annual payments that tobacco companies agreed to make to US states into “perpetuity.” It was part of the Master Settlement Agreement, or MSA, struck in 1998 between 46 states and Philip Morris, Lorillard, and Reynolds American. The annual payments into “perpetuity” are based on cigarette shipments. Turns out, “perpetuity” may not last much longer.

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The purpose of the settlement was to allow states to recoup healthcare costs related to the consequences of smoking. California was promised the most. Because states are states, and because California is California, they couldn’t wait to get this money on an annual basis and pay for smoking-related expenses as they occur. Instead, California and other states harnessed the genius of Wall Street, which harnessed the promised payment stream – which depends on cigarette shipments – to cobble together asset-backed securities that are free from federal taxes but require that Americans keep smoking at a certain rate.

Otherwise these bonds default.

It was a good deal. Wall Street got the fees. States got the moolah upfront. You got the bonds in your bond fund. States only spent 14.6% of the money from the settlement on the original purpose; the rest dissipated into their general funds.

A truly ingenious strategy. Cigarette shipments have swooned on average 3.4% per year since 2000. When the levy was hiked from $0.39 to $1.01 in 2009, shipments plunged by a record 9.1%. In 2013, shipments fell by 4.9%, the second largest decline on record, in part ascribed to the popularity of e-cigarettes, which went from zero to $2.2 billion in four years. And they’re not counted in the shipment formula of the MSA.

Cigarette shipments in the US may plummet by 68% over the next decade, while shipments of e-cigs may multiply 13-fold, estimated Wells Fargo analyst Bonnie Herzog, according toReuters. At that point, e-cig shipments would outnumber those of regular cigs. Since e-cigs aren’t included in the MSA, manufacturers don’t have to make payments based on shipments. This gives them an incentive to plow into the sector and induce smokers into switching to the cool new product. Tobacco companies can save billions that way.

Alas, many of the tobacco bonds were structured to survive shipment declines of only 2% to 3%.

They’re toast, Moody’s Investors Service said without quite phrasing it that way. It rates about 80% of these bonds at “B1” or below. So four notches or more below investment grade. In July 2012, Moody’s already pointed out that, if consumption kept falling at a 3% to 4% annual rate, 74% of the “aggregate outstanding balance of all the tobacco settlement bonds will default.”

“If the decline goes to 6% or 7%, it will be very quick,” Tom Metzold, portfolio manager at Eaton Vance Investment Managers, told Reuters recently. He’d dumped his tobacco bonds over a year ago. So when would they pop? “I think that the first ones are probably five years away.”

But they already exhibit stress. New Jersey announced earlier in June that it would draw $12.5 million from reserves to pay the interest. It cited “insufficient tobacco settlement revenues.” Ohio would draw $31.5 million from a reserve account. Virginia would do likewise.

Meanwhile, the e-cig solution for tobacco companies has triggered a feeding frenzy of e-cig makers. Number two, Reynolds American, and number three, Lorillard – whose e-cigs, acquired in 2012, have 50% of the US market – are exploring a merger. Reynolds began distributing e-cigs this month. Number one, Altria Group, will soon push its own brand. All in order to speed up the switch from regular cigs to e-cigs.

Tobacco bonds are dead. Um….

Enter the greatest credit bubble in history. It makes all things possible. Even zombies.

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