Don’t Judge a Book by Its Cover—Digging Beneath the Surface of Tobacco Bonds

These municipal bonds backed by the penalty tobacco manufacturers agreed to pay are a significant portion of the municipal bond high-yield index.

Franklin Templeton Fixed Income Group

PREVIEW

Many investors may question an investment in municipal bonds tied to tobacco companies. However, contrary to what the name might imply, tobacco settlement securitization bonds, or TSSBs, do not benefit from tobacco company profits. The factors driving their performance are much different from the bonds and stocks issued by tobacco companies for financing purposes. Unlike traditional corporate bonds, these municipal bonds are backed by the penalty, or settlement payments, that tobacco manufacturers agreed to pay to US states and territories on an annual basis for posing public health risks and costs. 

As tobacco bonds are a significant portion of the municipal bond high-yield index, we believe it is important to be aware of the exposures within the context of the high-yield municipal bond market. We generally remain cautious in the sector relative to the benchmark because of the downward trends in Master Settlement Agreement (MSA) payments, but we have continued to find pockets of investment opportunity with tobacco bonds that offer strong estimated performance potential and adequate breakeven rates, based on our analysis. Our extensive research emphasizes deciphering which quality bonds we believe can provide more attractive downside protection in the future.

This primer seeks to set the record straight, explaining:

  • The history and role of the sector in the context of the municipal bond market
  • How recent developments are impacting our approach to the space

 

WHAT ARE THE RISKS?

All investments involve risks, including possible loss of principal. Bond prices generally move in the opposite direction of interest rates. Thus, as prices of bonds in an investment portfolio adjust to a rise in interest rates, the value of the portfolio may decline. Investments in lower-rated bonds include higher risk of default and loss of principal. Changes in the credit rating of a bond, or in the credit rating or financial strength of a bond's issuer, insurer or guarantor, may affect the bond's value. Municipal bonds are debt securities issued by state and local governments and are generally exempt from federal income tax and also from state and local taxes for residents in the state where the bond was issued. They typically offer income, rather than capital appreciation potential. Corporate bonds are issued by corporations. Bonds with lower ratings and higher credit risk (risk of default) typically offer higher interest rates to compensate investors for the higher risk associated with the investment.