(UPDATED to reflect closing prices): High demand and state guarantees have enabled Pennsylvania to sell $1.5 billion in “tobacco bonds” backed by future revenues from the 20-year-old multi-state settlement with cigarette makers at better-then-expected prices, though still at a premium to more-solvent states.
The sale was designed to help Pennsylvania patch holes in its state budget without raising taxes, a onetime gimmick, warned Standard & Poor’s analyst Carol Spain in a report last month in advance of the sale. She rated the bonds A, a relatively low investment grade, noting that the commonwealth’s credit rating ranks with New Jersey and above Illinois among the lowest for U.S. states.
To make it easier to sell the bonds despite Pennsylvania’s relatively low rating, the state agreed to commit future sales-tax and hotel-tax revenues to pay off the bonds if tobacco-company payments drop, as some analysts have predicted, given the decline in U.S. cigarette use.
“The transaction was very positively received by investors and the true interest rate ended up at 3.88 percent,” said Michael Gerber, spokesman for the state Department of Community and Economic Development.
That’s still about 1 percentage point higher that what investors have been paying for bonds in such triple-A rated states as Maryland or Virginia. So Pennsylvania taxpayers will be paying up to $15 million a year extra in finance costs, compared with what it would likely pay if it cut spending or raised taxes to balance the budget. But market-watchers said buyers flooded the market anyway, cutting yields that had been set to close above 4 percent.
Pennsylvania sold the bonds at a convenient time for nervous investors, analysts told me. “The market has been on a roller coaster since early January,” said Glenn Williams, president and chief executive at A.H. Williams, a Philadelphia-based investment advisory firm that specializes in municipal bonds.
Investors have been looking for higher-yielding bonds to buy, given the early February stock market decline, the rising federal deficit since December’s U.S. income tax cuts, and inflation fears. And that kept Pennsylvania from paying significantly higher rates. “Even in sloppy markets, there are some values to be had,” Williams concluded.
Earlier in the sale, which was led by investment bank Jefferies LLC, the bonds had been offered at “yields of as much as 4.1 percent,” wrote analyst Eric Kazatsky in a report to clients of Bloomberg Intelligence.
Bloomberg says tobacco-bond prices fluctuate more than most muni bonds, giving buyers the hope of extra profits.
The Jan. 19 S&P report cited the state’s budget deficit for 2017 and the “onetime nature” of funding gimmicks approved by the governor and General Assembly, such as the tobacco-bond sale, as reasons for giving Pennsylvania a lower credit rating than other states.
Pennsylvania has been “misaligning” its spending and its tax income and suffers from a “chronic, structural imbalance” dating back to the administration of then-Gov. Ed Rendell, analyst Spain warned. It may need to “identify alternative-funding sources” for programs that had been funded with tobacco money before that was diverted to investors as a way of shoring up the state’s general revenues, she concluded.