Tobacco Bonds and Electronic Cigarettes by Mark Benson

Over the last few months the electronic cigarette industry has come in for some serious criticism from an array of different parties. The political arena has been one of the more vocal elements of this group and while politicians obviously have an obligation to protect the health of the general public, there is growing concern that financial pressures may also be coming into play.

One of these potential financial pressures revolves around $96 billion worth of tobacco bonds and the 1998 Master Settlement Agreement between large US tobacco companies and 46 US states. While there is little in the press with regards to tobacco bonds at this moment in time, some experts believe that they may well be headline news in the weeks, months and years to come.

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Why might tobacco hit the news?

Before look at issues relating to tobacco bonds it is worth noting what they are, why they were created and potential problems in the future. In simple terms, the 1998 legal settlement obliged large tobacco companies in the US to pay an annual compensation fee to the 46 states which was based upon the sale of tobacco products. This agreement has some time to go although rather than take smaller annual payments many US state authorities decided to issue so-called “Tobacco bonds” that were backed up by these annual payments.

The idea was that the US states would receive a large upfront payment and use the ongoing annual funds from tobacco companies to cover future interest payments on these bonds and eventual redemption. When the bonds were created they were structured to withstand a reduction in tobacco cigarette smoking of between 2% and 3% per annum. At the time, bearing in mind the electronic cigarette industry was relatively unknown, this seemed to be a sensible range and many investors promptly acquired these bonds.

So what has changed?

The most damaging aspect of the changing electronic cigarette/tobacco cigarette markets is the reduction in tobacco consumption. When you bear in mind these bonds were structured to withstand annual falls of between 2% and 3%, and the average annual rate is 3.4% since 2000, this may not seem overly worrying. However, this 0.4% deviation from the initial bond safety net is worrying in itself not to mention the fact that some experts believe the rate of decline in tobacco smoking could hit 7% per annum in the short to medium term.

As the rate of decline in tobacco smoking continues to accelerate, under the terms of the initial 1998 agreement, so the payments received from US tobacco companies are also falling. Even though many believe the electronic cigarette industry is still in its relative infancy there are already signs that some US state authorities are dipping into their reserves to cover shortfalls in interest payments. If this is correct, this is a situation which can only get worse in the short, medium and longer term with many experts believing that electronic cigarettes will overshadow their tobacco counterparts within 10 years.

Is this reason for concern?

The simple fact is that declining payments from US tobacco companies under the 1998 agreement will place more pressure upon these so-called tobacco bonds. As shortfalls emerge between interest payable and compensation received this will force more and more US states to dip into their financial reserves – or risk defaulting on the bonds they backed. We also have the issue of eventual redemption which could see many US states struggling to find the capital required to repay these bonds. While the amalgamation of income streams as a means of backing bond sales is nothing new, allowing the US authorities to create a large upfront payment, there are long-term obligations which need to be fulfilled. Many of these tobacco bonds have already fallen below investment grade status as dictated by the debt rating agencies and it seems that many experts believe there is more trouble ahead.

One interesting factor which has also emerged is that while the 1998 agreement was based upon additional health care costs which the 46 US states were looking to recoup, not all of the compensation received was directed back towards health care. It would appear that many of the US population were under the impression that all compensation payments from the US tobacco companies would be directed towards health care and there may be some difficult questions for politicians in the future.

In the interests of balance, it is worth noting that not all experts believe that electronic cigarettes will overshadow their tobacco counterparts within the next decade. Indeed some experts believe that electronic cigarettes will never truly challenge the tobacco cigarette industry. As is becoming apparent, nothing is ever straightforward in the tobacco/electronic cigarette industry where financial pressures seem to be taking their toll.

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Mark Benson

Mark Benson is a contributing author for Spinfuel eMagazine. His continuing columns will bring a levelheaded approach to the dynamics involved in realizing a positive future for the e-cigarette industry. For more information on OK Eliquids and other products available please visit the OKCigs website.

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