Thank You for Smoking?
What makes a bond a good impact investment? It’s a question we address daily as we evaluate issues for inclusion in SNW impact portfolios. Recently we were asked whether a specific “tobacco bond,” so called because it receives its funding from the 1998 Tobacco Master Settlement Agreement (MSA), could be included in an impact portfolio. The answer – and the way in which we arrived at it – offers insight into our process for evaluating specific bonds for impact.

A Primer on Tobacco Bonds

In 1998, the four big tobacco companies settled a lawsuit brought by the attorneys general of 46 states to recoup the costs of tobacco-related illnesses. Under the MSA, tobacco companies consented to several concessions, including making annual payments to states in perpetuity as compensation for tobacco-related healthcare costs.

MSA payments are based on the number of cigarettes shipped during the year, rather than tobacco industry profitability, so a reduction in the smoking rate would reduce MSA revenues. The reduction can be offset because the base MSA payment automatically increases each year by 3% or the rate of inflation, whichever is greater. In the first 25 years, the settlement guarantees a minimum payout of $206 billion to states. The MSA did not limit how states could use the funds, but it encouraged them to direct the resources toward tobacco control programs.

For the majority of the 46 states in the settlement, however, the temptation to use MSA funds for other purposes, for example, to cover state budget shortfalls without increasing taxes, won out. The securitization of the MSA income stream in the form of tobacco bonds was born of states’ desire to gain access to the funds up front.

The specific bond issue that drew our attention from an impact perspective was one brought to market in February 2018 by the Commonwealth of Pennsylvania (Tobacco Master Settlement Payment Revenue Bonds, Series 2018). The Commonwealth has stood out as a state that has directed its MSA funds toward the expected purposes, including subsidized nursing home care, pro-bono hospital care, state-funded health research, and smoking cessation programs.

Evaluating a Bond on Its Impact Merits

On its surface, an investment-grade bond specifically directed toward improving public health seems like a good fit for an impact portfolio. When we evaluate an issue, we look at four factors: the impact potential of an issuer, the use of bond proceeds, the source of funds, and investor expectations. Here’s the breakdown on the Commonwealth’s recent tobacco bond:

1. The Issuer’s Impact Potential

We’ve developed a proprietary, data-intensive process for evaluating the impact potential of municipal, government, agency, and corporate issuers. The Commonwealth of Pennsylvania is considered an eligible general obligation issuer for impact strategies, having scored a 3 out of 5 on our impact evaluation (the minimum threshold for inclusion).

2. Use of Proceeds

As mentioned earlier, to date the Commonwealth has allocated the majority of its MSA funding for the expected purposes. That will change in April 2019, however, when the bond in question will begin to direct proceeds into the Commonwealth General Fund to support general obligation debt.

The diversion of these funds removes any positive impact potential of the proceeds, other than the impact aspects common to general obligation debt issued by the Commonwealth. Further, by directing funds away from healthcare and tobacco control programs, the bond weakens the state’s commitment to programs with positive impacts through at least 2039 (the bond’s maturity date), solely in the interest of avoiding tax increases necessary to cover existing or future budget shortfalls.

Exhibit 1: <b>States Spend a Fraction of MSA Revenues on Tobacco Prevention</b>

3. Source of Funds

The bond becomes increasingly problematic from an impact perspective when viewed through a funding lens. Screens against tobacco manufacturers were among the first implemented by socially responsive investors back in 1928. Today these screens remain a feature of many socially responsible investing (SRI) strategies because many environmental, social, and governance (ESG) and impact investors simply don’t want to own tobacco-related investments. What’s more, the securitization of the MSA settlement creates a problematic tension in which the state has the ability to pit its own best fiscal interest against its efforts to reduce the impact of tobacco use.

4. Investor Expectations

While they are subjective and difficult to pin down (and are frequently overlooked by portfolio managers), investor expectations are essential to determining the suitability of a bond for an impact portfolio. We look at investor expectations on a case-by-case basis. In this case, the fact is that many investors have a negative reaction to the idea of tobacco-related investments based on the negative impacts of their products. Cigarette smoking is responsible for more than 480,000 deaths per year in the United States, including 41,000 deaths from exposure to secondhand smoke. Smokers die 10 years earlier, on average, than nonsmokers, and the total economic cost of smoking is more than $300 billion per year.

Based on this evaluation, the recent issuance from the Commonwealth of Pennsylvania cannot be considered for inclusion in SNW impact portfolios. Additionally, a very high bar is in place for any bonds supported by the MSA as a result of concerns about the source of funding and investor expectations. There are situations in which bonds funded by less impact-friendly sources might qualify – lottery bonds whose proceeds are required to be spent on education, for example, could make the grade despite misgivings about gambling. Through careful analysis, we weigh the pros and cons of each bond and issuer and make our impact determination.