(Bloomberg) -- Bill Gross says Pacific Investment Management Co. will smoke its competitors by year-end. Tobacco bonds from Ohio to California may help ignite returns at his flagship fund.

High-yield tobacco debt issued by states and cities has soared 16.3% in 2014, beating all parts of the municipal market, Barclays Plc data show. Yields at 11-month lows are sparking demand for the junk-rated assets even as Moody’s Investors Service forecasts a wave of defaults because of falling cigarette sales.

The securities’ appeal goes beyond their extra yield: The $94 billion corner of the market offers bonds that are easy to buy and sell in relatively large amounts. That includes munis from Ohio’s Buckeye Tobacco Settlement Financing Authority. The largest federally tax-free holding in Gross’s Total Return Fund, which trails most peers this year, is $284 million of Buckeye debt. The bonds’ rally is putting them on pace to earn 37% in 2014, according to data compiled by Bloomberg.

“In this situation, you always see people reaching for yield, and so a high-yield sector like tobacco tends to outperform,” said Timothy Milway, an analyst at New York-based BlackRock Inc., which oversees $108 billion of munis. Tobacco is “more liquid because of the size of the issues.”

1998 Accord

The tobacco-bond gains belie a drop in the revenue backing them. Domestic cigarette shipments fell 4.9% last year, the steepest decline since 2010, according to data from the National Association of Attorneys General.

Under a 1998 national settlement, Philip Morris USA, Lorillard Inc. and Reynolds American Inc. agreed to make annual payments to states in perpetuity to resolve liabilities for health-care costs related to smoking. Some states and cities borrowed against the funds, which are based on cigarette shipments.

States that securitized the cash stream include Ohio, which offered $5.5 billion of Buckeye Tobacco debt in 2007. Gross, Pimco’s 70-year-old chief investment officer, held some of that offering in the Total Return Fund as of Dec. 31, Bloomberg data show. The investment pool is the world’s largest bond fund.

The bonds have gained about 14% this year, for an annualized total return of 37%, using Bloomberg Valuation prices. The securities traded today at an average yield of 7.28%, the lowest since March.

Breaking Point

Moody’s predicts that the accelerating rate of decline in cigarette shipments will cause Gross’s Buckeye debt to default. From 65% to 80% of tobacco securities may fail to pay principal on time as demand for cigarettes falls short of assumptions, the company says.

The ratings firm ranks the bonds due in June 2047 at B3, six levels below investment grade. The Total Return Fund is also the biggest owner of tobacco debt from West Virginia maturing in 33 years, with a $155 million stake, Bloomberg data show. The securities have a B2 rating from Moody’s, which includes them among bonds that will probably default.

The default likelihood stems from rosy projections for cigarette shipments, which have declined each year since 2007. Tax increases at the federal, state and local level and e- cigarettes have contributed to depress demand.

In Jeopardy

The Buckeye debt due in 2047 won’t be able to afford principal payments if shipments fall on average by more than 3.2% annually, according to Moody’s. The West Virginia debt has a breaking point of 3.6%. Most rated tobacco bonds have speculative grades.

The Buckeye Tobacco bonds have already drawn on a reserve account to make interest payments, though that doesn’t count as a default under terms of the securities.

Falling shipments jeopardize timely principal repayment, especially on longer-maturity bonds. Asset managers at OppenheimerFunds Inc. say that presents opportunity for buyers willing to hold the securities for decades.

“Because there’s no definitive timeline of when you’re exactly going to be paid, bonds always tend to trade at a discount or a yield premium relative to other equally rated bonds,” said Michael Camarella, who helps oversee $28 billion of munis at OppenheimerFunds in New York. “We’ve been willing to take those risks. Tobacco and Puerto Rico are the two cheapest sectors right now.”

The large deal sizes fuel a more active market for tobacco bonds than for most state and local debt.

Liquidity Leaders

Four of the 10 most-traded munis last quarter by par amount were tobacco securities, according to the Municipal Securities Rulemaking Board. They were zero-coupon bonds from West Virginia and Ohio due in 2047 and two series of zero-coupon debt from New Jersey maturing in 2041.

The $230 billion Total Return Fund is about six times larger than the biggest fund focused on munis. That drives demand for larger stakes in local-government securities than typical for tax-exempt funds.

Gross said in a May 14 interview on Bloomberg Television that he’s focusing on high-yield bonds and risk assets, “which will be not high-returning, but basically stable and low-risk and low-volatility.”

“Believe me, by the end of 2014, Pimco’s going to be at the top, not close to the middle,” he said. “We’ve got a thesis here. We’re sticking to our guns.”

Agnes Crane, a spokeswoman for Pimco in New York, didn’t have an immediate comment. The asset manager is based in Newport Beach, California.

Trailing Peers

The Total Return Fund trailed 86% of peers over the past 12 months, though it has bested 74% in the past 30 days. It also owns tobacco bonds from California, Iowa, New Jersey and Rhode Island, Bloomberg data show.

The ease of trading tobacco securities can make them susceptible to declines during market sell-offs. Last year, amid the worst losses for munis since 2008, high-yield tobacco fell about 12%. Only speculative Puerto Rico debt and water and sewer bonds fell more, Barclays data show.

The risk of defaults is rising, according to a May 12 report from research firm Municipal Market Advisors. It cited e- cigarettes as well as President Barack Obama’s proposed budget for 2015, which would raise the federal excise tax to $1.95 per pack.

When the levy rose in 2009 to $1.01 from $0.39, cigarette shipments fell by an unprecedented 9.1%.

Localities are turning to sin taxes to repair budgets. Chicago Democratic Mayor Rahm Emanuel passed a 50-cent increase in November that made the city’s levies the highest in the nation.

Yet it’s the rise of e-cigarettes that gives BlackRock’s Milway the most pause.

“I question the concept that you have money in perpetuity, because at some point in 30 or 40 years, something like electronic cigarettes could totally replace traditional smoking,” Milway said.

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