Despite pressure from e-cigarettes, tobacco bonds continue to outperform municipal bonds

Despite a decline in cigarette sales, tobacco bonds are outperforming general municipal bond indices, according to the Wall Street Journal.

The tobacco bond index maintained by S&P Dow Jones has a total return of 134% over the 10-year period ending in mid-December, while the general municipal bond index only returned 34%. Between the end of October and mid-December, the tobacco index rose by 13% as overall bond yields fell.

In 1998, the largest tobacco companies in the U.S. agreed to pay $206 billion over 25 years to 52 U.S. states and territories in exchange for these regions dropping future legal claims related to the costs of treating smoking-related diseases.

At least 21 states or territories, along with some local entities within those states, chose to cash out early rather than wait for the funds to trickle in, transferring this risk to municipal bond investors.

Since the Master Settlement Agreement, tobacco bondholders have had to contend with the rise of non-combustible products like e-cigarettes, which do not count towards cash revenue.

The U.S. government has also threatened to ban menthol cigarettes, which account for about one-third of cigarette sales in the U.S. Excise taxes have also dampened demand. The consumer price index for tobacco products has risen 530% since 1997, while the overall consumer price index has increased by 93%.

On the other hand, tobacco companies have agreed to set their annual inflation-adjusted payments at a minimum of 3%. Over the years, this has resulted in states receiving more than they would have if payments were adjusted for actual inflation.

The recent surge in inflation has led to a roughly 20% increase in payments from 2019 to 2020.