In 2018, the tobacco Master Settlement Agreement (MSA) turns 20, and its many stakeholders – U.S. tobacco manufacturers, 46 states, the District of Columbia, and several U.S. territories – all have reasons to celebrate.
The participating tobacco manufacturers, for example, gained clarity about their financial obligations to the States when they signed the MSA.1 The agreement stipulated substantial initial payments and additional annual payments in perpetuity to the States. The participating manufacturers also agreed to limit their marketing, advertising, and lobbying activities.
For the States, the MSA provided relief from some of the healthcare costs associated with tobacco and smoking. The States receive annual payments from the MSA’s participating tobacco manufacturers, and each is free to spend the proceeds as it sees fit. Some payments have financed anti-smoking programs, and some have filled budget gaps or bolstered a State’s rainy day fund. Some States borrow against the payment stream by issuing tobacco bonds, which are secured by a pledge on future MSA payments.2
And that brings us to the stakeholders who are probably the happiest: the investors in tobacco bonds or in funds that hold tobacco bonds. They have, on occasion, had to deal with the volatility that is characteristic of high-yield securities, but they have also benefited from the sector’s strong performance.
How strong? For the 5 years ended December 31, 2017, the Bloomberg Barclays High Yield Tobacco Index had an average annual total return of 9.15%.3
As measured by the index, the tobacco sector outperformed the overall market in every year except 2013. For example:
- Tobacco bonds provided a total return of nearly 25% in 2012, which was three times the 2012 return of the Bloomberg Barclays Municipal Bond Index, which measures the performance of the general muni market.4
- In 2014, the tobacco sector provided a total return of 19.21%, more than 10 percentage points higher than the rest of the market, according to the Bloomberg Barclays indices.
- In 2015, the tobacco index’s total return was 15.75% compared to a return of 3.30% for the overall market.
- In 2016, the sector offered a total return of 4.44%, well above the overall muni market, which was virtually flat.
The 2017 trend year was also rewarding: While the total return of the muni market, as measured by the Bloomberg Barclays index was 5.45% at year-end, the Bloomberg Barclays high-yield tobacco index produced a total return of 21.5%.
The tobacco sector’s results look especially impressive, we believe, when you consider that they were achieved in a low-interest-rate environment and amid smoking-related trend stories that can trigger pricing pressure (e.g., declines in consumption or sales, increases in taxes).
What the trend stories often overlook is how prescient the MSA’s developers were. The MSA calculations that were established in 1998 factor in a number of built-in assumptions reflecting estimated declines in consumption and sales as well as anticipated increases in taxes levied on cigarette sales.
While some asset managers considered the assumptions and decided to avoid the sector or to limit their exposure to it, the Oppenheimer Municipal Fund Management Team assessed the potential risks of the sector and reached a different conclusion; after scouring the MSA, our team decided that the MSA’s inflation adjustments, built-in assumptions about consumption trends, and other provisions represented substantive protections for investors in tobacco bonds. For example, the amount a participating manufacturer pays is based on cigarettes shipped (not sold) domestically, and it increases annually by the inflation rate or 3%, whichever is greater. Also, the payments are based on each tobacco manufacturer’s share of the domestic cigarette market, and profitability is not a factor. A manufacturer that loses market share in a given year will pay a smaller share of the overall MSA payment, but another manufacturer’s share of the market (and payment) will likely rise.
According to the Centers for Disease Control, approximately 15% of American adults smoked cigarettes in 2016, the latest year for which national data is available. Healthy People 2020, an initiative of a broad array of federal agencies, seeks to reduce the percentage by another 3 percentage points by 2020. By way of comparison, in 1965, more than 40% of U.S. adults were smokers.
An estimated 258 billion cigarettes were sold in the U.S. in 2016, a decrease of about 2.5%. This rate of decline is fairly typical. The largest consumption decline occurred in 2009, after the federal excise tax rose to $1.01 per pack, a 259% increase. (The Great Recession, which ended in June 2009, may also have been a factor in declining consumption that year.)
State-levied excise taxes, which can also have an adverse effect on overall consumption and sales rates, have been rising in recent years. According to the Campaign for Tobacco-Free Kids, the average state cigarette tax was $1.72 a pack as of January 1, 2018.5 California’s decision to increase its excise tax by $2 a pack on April 1 helped elevate the average in 2017.
As we have seen over the years, tobacco bonds can encounter price volatility if investors fail to think about the MSA’s built-in assumptions when there is news about smoking rates, sales, taxes, and other tobacco-related topics.
Sometimes, even headlines about far-off and far-from-certain changes in tobacco regulation can lead to short-term volatility in tobacco bond prices. In 2017, for example, there was a midsummer selloff and then a rebound in tobacco bonds after a Food and Drug Administration (FDA) press briefing about its plans “to begin a public dialogue about lowering nicotine levels in combustible cigarettes to non-addictive levels through achievable product standards.”
While the market reacted swiftly – tobacco stocks were rattled – the American Lung Association, among others, questioned the FDA’s ability to do the same. As a proof point of its contention that progress would likely be slow, the lung association reminded a reporter for thehill.com that the FDA has yet to act on a 2011 recommendation to ban the sale of menthol cigarettes.6 The FDA’s latest announcement calls for further public comment on flavored tobacco products, including menthol cigarettes.
It will likely take many years for the FDA to transform its new vision for low-nicotine products into an actionable plan, just as it has taken the FDA years to articulate this vision. The FDA, it should be noted, has had the power to regulate the tobacco industry since 2009 and has been funding ongoing research designed to evaluate potential nicotine standards and implementation concerns since 2012.
Given the strength of the tobacco lobby, the need to deal with many stakeholders, and the potential for bureaucratic processes to interfere with the FDA’s stated intentions, we believe the long-term impact (if any) of this announcement cannot be accurately assessed.
As active managers focused on our shareholders’ best interests, we constantly monitor our portfolios and make adjustments to the funds’ holdings in our pursuit of competitive levels of tax-free income and yield-driven total returns. When we saw opportunities in 2016 and 2017 to take advantage of price appreciation and simultaneously lessen our funds’ exposure to below-investment-grade securities, our fund complex sold some tobacco holdings.
Our long-term view of the sector remains bullish and, given attractive relative values, our funds sold some tobacco holdings.
During 2018, our team plans to celebrate the 20th anniversary of the MSA by providing more frequent updates about the landmark agreement and the tobacco sector, so watch this space!
- ^Initially, four tobacco manufacturers signed the MSA. Now, more than 30 have. The geographic entities that signed the MSA are known collectively as the “States.”
- ^States that issue MSA-backed tobacco bonds will receive an upfront – and often sizable – cash payment that can be put to immediate use. These States are then required to use their annual MSA disbursements to pay the bonds’ principal and interest.
- ^The Bloomberg Barclays High Yield Tobacco Index measures the performance of non-investment-grade, tax-exempt municipal bonds that are backed by the proceeds of the tobacco Master Settlement Agreement. Indices cannot be purchased by investors. Index performance includes reinvestment of income but does not reflect transaction costs, fees, expenses or taxes. Index performance is shown for illustrative purposes and does not predict or depict fund performance.
- ^The Bloomberg Barclays Municipal Bond Index is an index of investment-grade municipal bonds.
- ^This figure excludes the federal tax of $1.01 per pack as well as any local taxes that may be imposed.
- ^The recommendation was made by the Tobacco Products Scientific Advisory Committee, which was established by the Family Smoking Prevention and Tobacco Control Act of 2009.
Fixed income investing entails credit and interest rate risks. Interest rate risk is the risk that rising interest rates, or an expectation of rising interest rates in the near future, will cause the values of a Fund’s investments to decline. Risks associated with rising interest rates are heightened given that rates in the U.S. are at, or near, historic lows. When interest rates rise, bond prices fall and a fund’s share price can fall. Municipal bonds are subject to default on income and principal payments. Further, a portion of some funds’ distributions may be taxable and may increase alternative minimum tax (AMT) for investors subject to that tax; distributions from net realized capital gains are taxable as capital gains.
The funds invest in below-investment-grade debt securities, which may entail greater credit risks, as described in each fund’s prospectus. These securities (sometimes called “junk bonds”) may be subject to greater price fluctuations and risks of loss of income and principal than investment-grade municipal securities. The funds may invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. The funds may also invest substantially in Puerto Rico and other U.S. territories, commonwealths and possessions, and could be exposed to their local political and economic conditions. Deterioration of the Puerto Rican economy could have an adverse impact on Puerto Rican bonds and the performance of the Rochester municipal funds that hold them.