By any other name would smell as sweet.”
What do Juliet’s famous lines to Romeo have to do with the municipal bond market? Actually, more than you might imagine.
On Tuesday, February 13, Pennsylvania came to market with “tobacco bonds,” or so many were led to believe. Even The Bond Buyer, which has covered the ins and outs of the municipal bond market since 1891, wrote about the oversubscribed sale of tobacco bonds. One market participant referred to investors’ interest in these tobacco bonds, which have a 5% coupon, as “a riot.”
Several Oppenheimer Rochester funds purchased these bonds, which were offered by the Commonwealth Financing Authority. In all, Oppenheimer Rochester AMT-Free Municipal Fund, Oppenheimer Rochester High Yield Municipal Fund, Oppenheimer Rochester Intermediate Term Municipal Fund, and our long-term fund for Pennsylvania investors acquired $22.5 million of the $1.5 billion sold that day.
This type of investment rarely warrants a write-up, given that our portfolio team has long championed securities backed by a municipality’s share of the proceeds of the landmark 1998 tobacco Master Settlement Agreement (the MSA) and that this acquisition is not particularly sizable.
So, why write about this sale? It turns out that these tobacco bonds are … wait for it … not tobacco bonds. Pennsylvania did not securitize its future MSA payments, and the debt service on the bonds it sold in mid-February are, in fact, backed by budget appropriations. Pennsylvania has committed to using its general appropriation pledge if its debt-service payment exceeds the MSA payment. In other words, the bonds in question are investment-grade, double-barreled government appropriations securities.
As an asset manager that has often taken some heat because of our overweight positions in tobacco bonds – even when the sector has been a top performer, as has been the case in many recent years – we were rather amused to see Pennsylvania position this offering as a tobacco bond.
The decision to issue these bonds was made in October 2017, when legislators were unable to close a budget gap that had reached $2.2 billion. They plan to use the proceeds from the sale to help close the gap and to expand casino gambling as a way to boost revenues. To the legislators, the bonds seemed preferable to other means of deficit reduction, such as raising taxes or cutting services.
Speaking of taxes, we expect to see many changes to tax codes at the state and local level as elected officials and budget offices come to terms with the long-term implications of the federal Tax Cuts and Jobs Act of 2017. We also expect to see strong demand in the muni market—driven by investors’ greater needs for tax-free income and magnified by the low-interest-rate environment and below-average levels of new money issuance. As for government appropriations bonds that masquerade as tobacco bonds? We’d be surprised to see that become a trend, but then again, we bet many investors were surprised to learn that it happened even once.
Fixed income investing can entail credit and interest rate risks; as interest rates rise, bond prices generally fall and a fund’s share price can fall, too. A portion of a municipal bond fund’s distributions may be subject to tax and may increase taxes for investors subject to federal alternative minimum tax. Capital gains distributions are taxable as capital gains.
Below-investment-grade (“high yield” or “junk”) bonds are more at risk of default and are subject to liquidity risk. Under certain market conditions, some unrated securities may trade less actively than rated securities. Our funds can have a relatively high portion of their portfolio holdings in particular segments of the municipal securities market, such as tobacco bonds or real-estate-related securities. They may also invest substantially in municipal securities within a single state or related to similar type projects, which can increase volatility and exposure to regional issues. 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. Diversification does not guarantee profit or protect against loss.