There is over $100bn notional outstanding of municipal tobacco bonds, and the coupons are paid from settlement money that state and local governments receive from tobacco companies. Many of these bonds are below investment grade for two primary reasons: first, the debt is not guaranteed by the municipalities which issued it, and second, smoking among Americans is expected to continue to decline (deliveries have declined 4.5% on average since 2007). If these declines continue at the same rate, almost 80% of the total outstanding issuance is expected to become impaired.

The Alcohol and Tobacco Tax and Trade Bureau released a monthly report which tracks the number of cigarettes and cigars manufactured each month, and this report is market-moving for tobacco bonds, especially if there is an unexpected increase in production.

Research has shown that manufacturing numbers can be predicted very accurately through surveys, specifically surveying smokers’ purchasing habits on a monthly basis. Roughly 25BN cigarettes are produced each month - most of which are consumed. 17.8% of U.S. Adults are smokers, which translates to ~19 cigarettes/day, or roughly 1 pack/day, for the average smoker. While it is important to check if surveyed results match expectations, what really matters is the underlying trend in smokers’ purchasing habits as an unexpected increase or decrease in smoking trends can significantly move prices of these tobacco bonds. Surveying 1000 people monthly only costs ~$1000 dollars. On a very large position, this is relatively nothing - any uptick in smoking trends (given the expected 3-4% decline) could really make these bonds jump once the monthly reporting statistics are released.

One bond that is very sensitive to cigarette purchases are the Ohio Buckeye Zeros (CUSIP 118217AW8):

ohio Ohio Buckeye Zeros (CUSIP 118217AW8) - Tobacco Settlement Asset Backed First Subordinate (CAB) Turbo

Turbos are extremely levered to increased shipments and even simply a reduction in the rate decline can cause these bonds to rally substantially as they are last to receive settlement payments and most investors expect these bonds ultimately to be worth zero (some even own then as a cheap inflation hedge). Being able to see an inflection in the delivery numbers (which occurred in 2014) allows an investor to size a decently large trade in the turbos or other more liquid tobacco bonds with more downside protection than the market believes. There are many additional turbos which we believe are interesting, you can find more on the EMMA website. These are the types of situations we enjoy - very asymmetric assets with quantifiable catalysts which we believe we can measure better than other market participants.

Tobacco bonds (especially turbos) also have additional upside that state governments will decide to assume the liability or refinance / present a tender offer for bonds given the extreme low rate environment. This happened in NJ with the NJ turbos shown below in 2014.


TOBACCO SETTLEMENT FINANCING CORP NJ (CUSIP 888808DG4) - Tobacco Settlement Asset-Backed (First Subordinate)

Update 6/10/2016:

There is currently a public survey running quarterly roughly tracking these numbers. I would ask the questions a bit differently and wrap the ranges closer to 20, but the general structure of the survey is applicable to this problem. View the survey inline below: