(Bloomberg) -- Tobacco bonds faltered to become the worst performers in high-yield municipal debt as a decline in smoking drove the payments that back the securities to a record low. 

The debt dropped 0.4% in the year to May 7 compared to a 2.3% gain for the high-yield tax-exempt market, according to data compiled by Bloomberg. US states are receiving a combined $5.8 billion from tobacco companies this year, the smallest amount since payments from their legal settlement, which are linked to cigarette shipments, started in 1999.

Though shipments have fallen as the share of Americans who smoke has dropped — government data show almost 12% of US adults are smokers, down from 21% in 2005 — the April announcement on the size of this year’s settlement payments nevertheless took investors by surprise. A shrinking supply of the securities and investors’ search for yield may yet help the bonds recover. 

“It’s almost like there was a knee-jerk reaction,” said Eric Kazatsky, a strategist at Bloomberg Intelligence. There’s potential for a bounce back because, “with everybody scrounging for yield, any little bit of incremental spread is helpful.”

Speculative-rated tobacco debt now yields 6.2%, higher than the 5.5% available in the broader high-yield index. The bonds had a banner 2023, handing investors a 12% return in part because the well-established settlement between the states and manufacturers tends to attract investors.

As investors shake off the shock from the low amount of the annual payment, the securities’ scarcity may help boost their performance. A wave of refinancings produced bonds with stronger repayment pledges, helping them get upgraded to investment grade — and taking them out of the index. Tobacco debt’s share in the high-yield gauge has dropped to 6.1% from 15% in 2019, BI data show.

Read More: High Yield Muni Tobacco Bonds Struggle as Nicotine Trends Evolve

Additional support may come from the Biden administration’s decision last month to delay a potential ban on menthol cigarettes, something that’s a positive for the sector, Barclays analysts Mikhail Foux and Clare Pickering wrote in a May 3 report. Still, the pullback from last year’s strong run there may be more short-term pain to come for the securities. 

“This complex has started to look more interesting, but with its levels well below the highs of last October, we might see further weakening in the near term,” they wrote.

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