2 Ratings Firms May Downgrade Tobacco Settlement Bonds

California may have to pay higher interest rates on its next planned sale of tobacco settlement bonds, after two credit rating firms said Wednesday that they may downgrade all such securities because of a recent court judgment.

Standard & Poor’s and rival Fitch Ratings said they placed $18 billion of tobacco bonds under ratings review, after an Illinois trial judge’s finding last week that cigarette giant Philip Morris USA deceived smokers into thinking that “light” cigarettes were safer than regular cigarettes.

The judge said Philip Morris was liable for $10.1 billion in damages. S&P; and Fitch said the court decision, though under appeal, could affect the financial flexibility of Philip Morris parent Altria Group Inc.

Altria and other major tobacco firms in 1998 agreed to pay more than $200 billion to states and municipalities over 25 years to settle the states’ health-liability suits against the industry.

In turn, many of the states, including California, have sold bonds backed by the tobacco companies’ future payments. The bonds in effect allow the states to advance themselves some of the settlement money, which can be used to plug current budget gaps.

Because the bonds are to be paid off by the tobacco companies, the securities’ credit ratings depend on the financial health of the companies. S&P; and Fitch currently rate the bonds in the “A” range. The warnings Wednesday were that those ratings may be lowered -- which could mean investors will demand higher yields on any new tobacco bond offerings to compensate for the higher risk.

California sold $3 billion in tobacco bonds in January and paid annualized yields as high as 7% -- exempt from federal and state income tax -- on the longest-term securities.

The state plans to sell an additional $2.3 billion of the bonds April 15.

“California is stuck -- they need the deal” to help close the state budget gap, said Stephen Galiani, a municipal bond fund manager at Wells Fargo Capital Management in San Francisco. “The deal will get done, but it will be very expensive.”

He estimated the state may have to pay more than 7% on the next batch of bonds to entice buyers.

Barbara Lloyd, a California deputy state treasurer, said the state is “monitoring and evaluating the market’s response” to the threat of lower bond ratings, and will “work with the financing team to structure the bonds in the most cost-effective manner.”

Other states have sold tobacco securities with the backing of certain public assets, to give investors’ more comfort and allow for lower yields on the bonds. But it isn’t clear that California can do the same, Galiani said.

Some bond market pros said investors in tobacco bonds must be prepared for more court decisions that could hurt the bonds’ image. Still, “I think that overall these bonds are ‘money good,’ ” said David MacEwen, chief investment officer for American Century funds in Mountain View, Calif. His firm owns some tobacco issues, and he noted that the tax-free yields are far above what most municipal bonds pay.

S&P; said it sees no “imminent danger of payment default” on tobacco bonds. But it said the Illinois case “could mark the beginning of longer-term credit deterioration of both the industry and these issues.”