By Lisa Lambert

WASHINGTON, Dec 20 (Reuters) - A deal announced this week with tobacco companies will distribute money that has been tied up for years to 17 states, but the funds may provide only short-term relief to underfunded tobacco bonds.

Cigarette makers, including Philip Morris USA and R.J. Reynolds Tobacco Co, on Tuesday announced a settlement with the states in a long-running dispute over the amount of payments they are required to make under the 1998 landmark anti-smoking agreement.

The settlement gives states a share of $4 billion in disputed payments currently held in escrow. The manufacturers will receive credits against future payments.

Rating agencies have recently raised red flags that declining tobacco consumption could affect the future of those bonds. The settlement will provide certainty and will free up some cash, but it will likely not wipe out the risk of defaults on the debt, said Richard Larkin, senior vice president of Herbert J. Sims & Co, Inc and a longtime tobacco bond analyst.

The deal will be "a one-time windfall that will improve debt coverage in 2013, but that windfall will be reduced by the 50 percent refund requirements," said Larkin.

He said a total of $1.68 billion will be paid to the states in April 2013, but cigarette companies will receive $1.6 billion in refunds over the next five years as credits.

The 1998 agreement, which involved almost all 50 states, included a section designed to level the playing field between companies that signed it and those that did not. It cut the signing companies' payments to the states by an amount equivalent to the market share the companies lost to the firms that did not sign the agreement.

Those reductions created a long-standing fight, with the participating companies arguing that their sales are not big enough to justify payments. They put the sums they dispute into escrow, keeping states, the District of Columbia and Puerto Rico from collecting the money.

"The settlement, if approved, will increase the amount of money that the District receives," said David Umansky, spokesman for Washington D.C.'s chief financial officer. "In particular, the settlement will limit the ability of tobacco companies to withhold amounts from future payments to the District."

Georgia will get $56 million in 2013 from the settlement, said state Attorney General Sam Olens. He added that the agreement saved the state legal costs and ensures continued cash flows in the future that are now mostly used for health programs.

"We did not securitize any of our tobacco funds. It will not impact any of our outstanding debts," said Susan Ridley, director of Georgia's Financing and Investment Division.

Arkansas sold only about $5 million in bonds, and the $24.2 million it receives in 2013 from the settlement will mostly go to the state's public health programs dealing with cigarette addiction, according to Brad Phelps, the state's deputy attorney-general, who helped craft the settlement.

States, counties and cities have sold nearly $40 billion of bonds backed by the more than $200 billion in payments that U.S. cigarette makers agreed to make to them over time.

"I know this is good for tobacco bonds but it's not like it completely solved the shortfall problems," Larkin said, noting the companies' credits will mean states do not receive the total sum they anticipated. "They're not going to get as much money as they originally thought, but they're going to get more money than they were getting.

"It's just going to delay the year when they run out of money and they don't have enough to cover all their bonds. It's a major development, but it's very complicated," he said.

California, one of the largest issuers of tobacco bonds, said the settlement would provide no new net benefit to its bottom line. The bonds were sold by the Golden State Tobacco Corporation, which in turn paid the state, according to the state treasury department, and that corporation is entitled to any proceeds.

Attorneys general for New Jersey and Virginia, also major tobacco bond issuers, did not respond to requests for comment. According to Standard & Poor's, Virginia has sold more than $1 billion in tobacco bonds, and New Jersey more than $3.5 billion.

Larkin analyzed how the terms of the settlement would affect Virginia. In 2013, the state would receive $82 million "freed escrow funds, but would simultaneously also see about $38 million held back for the refund," he wrote in a note on the settlement. The net new funds to the state over the next five years would be only about $7 million.

Virginia and California have had to tap reserves to repay bondholders and "the 2013 windfall would allow them to actually add back to reserve funds," Larkin wrote. "In 2014, however, renewed refunds will weaken cash flow and perhaps put these states into a situation where reserves will again be needed."

The other states in the settlement - Alabama, Arizona, Kansas, Louisiana, Michigan, Nebraska, Nevada, New Hampshire, North Carolina, Tennessee, West Virginia and Wyoming - also could not be reached for comment. Puerto Rico is part of the settlement, as well.

If more states join the settlement, the percentage of refunds to the companies could be reduced, Larkin said.

"If nothing changes and no new states sign the agreement, cash flow shortages and slower than expected turbo redemptions will continue to leave states like California and New Jersey with projected bond defaults in about 17-22 years unless consumption declines improve," Larking concluded.

In July, Moody's Investors Service warned that the majority of tobacco bonds will default if cigarette consumption keeps falling at a 3 percent to 4 percent pace.

The debt often outperforms the rest of the $3.7 trillion U.S. municipal bond market.

(Additional reporting by Michael Connor)

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