April 14 (Bloomberg) -- The municipal market is telling us not to worry too much about tobacco bonds.

See for yourself. Go to the Municipalbonds.com Web site, and call up the section on tobacco bonds, which Kevin Olson added to the site just this year.

Click on the latest date, and behold: Tobacco bonds, those bonds sold by states and municipalities and secured either in whole or in part by a percentage of domestic cigarette sales, are now trading at prices in the 90s and even at par, for the most part. Last year many of them were in the 70s and 80s.

``People are slowly figuring out that they aren't making them any more,'' said Ron Fielding, senior vice president at OppenheimerFunds Inc., who holds $2 billion in tobacco bonds among the $14 billion in municipals he manages.

``In 2003, they expected $15 billion in tobacco bonds to be sold; $5 billion were. None were issued during the first quarter of this year,'' said Fielding.

Two factors account for tobacco bonds' rebound, says Fielding. Most of them have high coupons -- ``a 6.5 percent coupon is pretty defensive right now,'' he says. And, when the bonds were first sold in 2000, the consumption projections used to calculate debt service always presumed a big decline in smoking, from 430 billion people in 2000 to 247 billion in 2032.

Event Risk
``There are no big surprises here,'' says Fielding, who adds that last week he bought more tobacco bonds for the seven funds he manages. He attributes the top showing of his funds for the first quarter -- Lipper Inc. ranks Fielding's funds at the head of its general municipal debt category -- to his holdings of both tobacco and airline bonds.

This isn't to say the road ahead is smooth. ``We're event- risk driven in this sector,'' said John Hallacy, head of municipal research at Merrill Lynch & Co. ``The tone is better. The legal horizon isn't clear. There's the Freedom Holdings case. And last year at this time we were sweating it out in Illinois.''

The Freedom Holdings case refers to a lawsuit brought earlier this year by Freedom Holdings Inc. and other cigarette importers that weren't party to the 1998 settlement. That accord gives states a percentage of domestic sales in perpetuity to compensate them for the costs of smoking-related illnesses. The lawsuit alleges that the New York law to collect payments from companies outside the settlement violates the Sherman Antitrust Act.

Last Year
And last year, Altria Group Inc., parent of Philip Morris, said it might have to consider bankruptcy if it was required to post a bond of $12 billion, an amount that was later reduced.

``It's not like the coast is clear,'' says Hallacy.

It's not. Which is why what the municipal bond market is telling us is so puzzling. Here's the tobacco industry facing a future lined with lawsuits yet investors seem undaunted.

Consider the 6.375 percent bonds due in 2032 sold by the Badger Tobacco Asset Securitization Corp. in Wisconsin in 2002. The bonds are taxable in Wisconsin, federally tax-exempt. They were originally priced at 97.073 to yield 6.60 percent.

These bonds were sold when it was still possible to sell a ``pure'' tobacco bond, backed entirely by the settlement. States and municipalities last year found that they had to promise investors that they would make up any shortfall in tobacco revenue, in order to get these transactions done.

These Wisconsin bonds began 2003 trading at prices in the 90s to 101. In mid-January, if you wanted to buy them, they would cost anywhere from 98 to 100.75. If you wanted to sell them, dealers were paying about 95.25.

Blithe Spirits
Fair enough. On March 26, 2003, Standard & Poor's raised the possibility that Altria Group might have to consider bankruptcy as a result of the Illinois case. By early April, you could buy these Wisconsin bonds at prices of around 80 cents on the dollar, and sell them in the 70-cent range.

Altria didn't go broke. By the end of 2003, prices on the Wisconsin bonds, and most others, climbed back to the 90s. Last month, some investors were willing to pay 100 cents on the dollar for these bonds. It's as if bond buyers everywhere expect sweet reason to answer every piece of litigation, no matter how potentially ruinous.

States and municipalities, which have sold almost $20 billion in municipal bonds backed by the tobacco settlement, must think so, too. Unruffled, they will collect their annual payment from the settlement tomorrow.

The General Accounting Office, which every year reports on the payments, says they will receive $5.2 billion, down from $6.3 billion last year.

Using the Money
And how will they use that tobacco money? The GAO says that the states will use 54 percent of the payments to meet budget shortfalls in fiscal 2004, up from 36 percent in 2003. They spent 24 percent of the payments on health care last year, which will fall to 17 percent this year.

The GAO also expects states and municipalities to sell another $6.2 billion in tobacco bonds. It looks like there will be lots of demand for them.

Last Updated: April 14, 2004 00:01 EDT