Fitch Ratings likes what it sees in tobacco bonds.
The ratings agency put all of the tobacco bonds it rates on “ratings watch positive,” indicating that it’s poised to raise their ratings.
Fitch cited a more favorable legal environment for the tobacco industry and said the major tobacco companies’ improved balance sheets was also a contributing factor.
This is a natural progression for Fitch, which recently upgraded the corporate rating for the U.S. tobacco industry to BBB from BBB-.
Fitch’s ratings on the senior tobacco settlement bonds can be as high as one notch above the general industry rating. Fitch believes that in the event of bankruptcy, the Master Settlement Agreement (MSA) would be viewed as an executory contract, in which the manufacturer would likely choose to continue making payments under the MSA in order to retain the benefits derived under the agreement.
Fitch also identified negative factors that could adversely affect the industry, such as rising cigarette taxes and the spread of smoking bans throughout the country.
Despite these challenges, Fitch emphasized that the tobacco businesses generate substantial free cash flow.
In recent years, tobacco bonds have proven to be extremely rewarding for tax-free bond investors. Although they carry investment-grade ratings, tobacco bonds often yield 100 basis points (1 full percentage point) more than their similarly rated counterparts.
Investors in these securities have also enjoyed significant capital gains as these higher paying bonds have been pre-refunded (refinanced) over the last few years.
Fitch anticipates that most upgrades will be limited to one notch. This would give most tobacco bonds a solid investment grade rating of BBB+.