The rapid growth of electronic cigarette sales poses a rising but under-appreciated risk to holders of as much as $96 billion of bonds tied to payments tobacco companies make to U.S. states from a sweeping legal settlement in 1998.
Tobacco bonds were already forecast by many analysts to begin defaulting within the next 10 years. That's because Americans have given up smoking at a faster rate than estimated when most of the bonds were sold in the previous decade.
Cigarette consumption has dropped an annual average 3.4 percent since 2000 while many bonds were structured to withstand consumption declines of only 2 to 3 percent.
But as smokers swap traditional cigarettes for tobacco-free e-cigarettes and other vaping products, the smoking rate is declining even faster and analysts now predict some bonds could go into default before the end of this decade.
"If the decline goes to 6 or 7 percent, it will be very quick," said Tom Metzold, portfolio manager at Eaton Vance Investment Managers. "I think that the first ones are probably five years away," he said in reference to defaults.
While still a small part of the cigarette market, sales of e-cigarettes and vaporizers have already grown to be worth more than $2.2 billion from next to nothing four years ago. By some estimates, they will capture more than half the smoking market within a decade, and tobacco companies are already jockeying for leading positions as that change unfolds.
"We believe consumption of e-vapor will eclipse consumption of combustible cigs over the next decade as technology improves," wrote Bonnie Herzog, analyst at Wells Fargo, who has tracked the tobacco industry for years, in a recent report.
Last month, Reuters reported that Reynolds American Inc. and Lorillard Inc., the second and third U.S. cigarette makers, were exploring a merger. Lorillard's leading blu e-cigarette brand, which has roughly 50 percent of the U.S. market, is seen as one of the appeals of the deal to Reynolds.
Under the Master Settlement Agreement, or MSA, struck 16 years ago between the biggest U.S. tobacco companies and 46 U.S. states, the companies make annual payments to the states using a complex formula tied to U.S. tobacco shipments. The accord ended years of litigation brought by the states, which had sought to recoup healthcare costs for treating ailments tied to smoking.
The states with the highest populations, such as California and New York, are owed the most. The majority of them arranged to get much of their money up front by selling bonds and pledging the annual payments to the bond holders.
The only problem is that as tobacco shipments decline, so do the payments. And sales of e-cigarettes, which now appear to be helping to accelerate the tobacco-consumption decline rate, are not counted as cigarette sales under the MSA.
The outlook for tobacco bonds is so dire that a forecast last month from Moody's Investors Service predicted 65 to 80 percent were headed toward default.
ALREADY AT RISK
Tobacco bond analysts have blamed the decline in consumption of cigarettes on public smoking bans and new excise taxes, until now.
Last year, cigarette shipments dropped by 4.9 percent, the biggest decline since the government passed a federal excise tax in 2009, a drop some blame on the rising popularity of the industry's new tobacco-free alternatives, such as e-cigarettes.
"The only cause I can attribute it to is e-cigarettes," said Alan Schankel, managing director of Janney Capital Market's Fixed Income Strategy team. "I think they are having an impact."
In 2013, Americans purchased 13.3 billion packs of cigarettes and 400,000 equivalent packs of e-cigarettes, versus 14.1 billion packs of cigarettes and 200,000 equivalent e-cigarettes in 2012.
Wells Fargo Securities predicts the pace at which consumers switch from traditional cigarettes to e-vapor alternatives will surge in the coming years. It estimates that sales volumes for traditional cigare