Fitch Ratings just released a special report which sums up the situation nicely for tax-exempt borrowers: too many LOC-backed bonds, not enough banks. Hospitals looking to renew letters of credit in 2011 better start looking at alternatives now, particularly providers below the "A-" rating category.
$15 billion in healthcare letters of credit and bank liquidity facilities are estimated to come due in 2011, three times the 2010 levels. This is largely the result of a glut of variable rate demand bonds issued in 2008 as many borrowers converted auction rate bonds to VRDBs in the wake of the auction rate market collapse. Backed by LOCs with a 3- to 5-year maturity, VRDBs achieved a low floating rate, but added bank renewal risk.
Renewals are of great concern because bank LOC capacity has shrunk dramatically since 2008. The resulting supply/demand imbalance is disproportionately affecting lower-rated borrowers below the "A-" level, since they have fewer options at their disposal. Having said that, all hospitals with expiring LOCs in 2011 will be faced with a risk/cost tradeoff, regardless of their respective ratings. The options are very limited indeed.
Fitch considers a fixed rate takeout the most prudent option since it eliminates renewal risk, put risk, and interest rate risk at once. Unfortunately, fixed rate refundings are costly since 1) one goes from a low floating rate to a higher fixed rate, and 2) any pay-fixed swaps must be terminated, the sooner the better due to the cost of carry. Since most of these swaps are under water in today's low rate environment, termination means an immediate hit to liquidity — or to debt service if the payment is financed.
The major alternatives to fixed rate bonds include short-term notes such as floating rate notes and direct bank loans. In today's rate environment, these options are cheaper than fixed rate debt since they keep the coupon low and any pay-fixed swaps can be left in place to hedge the new debt. However, floating rate notes are generally not available to lower-investment grade borrowers, and they present renewal risk in addition to interest rate risk. Bank Qualified loans, a popular alternative in 2010, involve the same risks and may not be an option if the $30 million BQ cap is not extended.
In general, hospitals are well-advised to avoid managing to their ratings. Rating agencies get paid to anticipate risk and analysts like the predictability of fixed rate debt, even if it means higher debt service for borrowers. The certainty of a fixed rate coupon may make life a little easier for everybody, but the coupon itself and the cost of terminating swaps can quickly drain a hospital's liquidity.
Instead of rushing to fixed rate debt, the decision to restructure VRDBs should be the result of a careful evaluation, one that balances cost vs. risk. Stress-testing the capital structure can be an effective tool to estimate the impact of various refinancing options on key financial metrics and credit ratings. Rating agencies do this primarily by projecting LOC term outs and higher interest expense. Hospitals ought to take the analysis to the next level and stress-test the entire balance sheet, debt, swaps and investments. This will facilitate making optimal, risk-adjusted decisions about LOCs coming up for renewal.
Putting the balance sheet through the paces provides additional dividends: by demonstrating that effective financial risk management procedures are in place, the hospital's credit ratings will also benefit.
For hospitals with LOCs expiring in 2011, the time to do this is now.
HFA Partners an independent financial advisory firm whose mission is to help hospitals and other healthcare providers mitigate financial risk, optimize the capital structure and access debt markets on the most favorable terms. For more information, please visit www.hfapartners.com.
$15 billion in healthcare letters of credit and bank liquidity facilities are estimated to come due in 2011, three times the 2010 levels. This is largely the result of a glut of variable rate demand bonds issued in 2008 as many borrowers converted auction rate bonds to VRDBs in the wake of the auction rate market collapse. Backed by LOCs with a 3- to 5-year maturity, VRDBs achieved a low floating rate, but added bank renewal risk.
Renewals are of great concern because bank LOC capacity has shrunk dramatically since 2008. The resulting supply/demand imbalance is disproportionately affecting lower-rated borrowers below the "A-" level, since they have fewer options at their disposal. Having said that, all hospitals with expiring LOCs in 2011 will be faced with a risk/cost tradeoff, regardless of their respective ratings. The options are very limited indeed.
Fitch considers a fixed rate takeout the most prudent option since it eliminates renewal risk, put risk, and interest rate risk at once. Unfortunately, fixed rate refundings are costly since 1) one goes from a low floating rate to a higher fixed rate, and 2) any pay-fixed swaps must be terminated, the sooner the better due to the cost of carry. Since most of these swaps are under water in today's low rate environment, termination means an immediate hit to liquidity — or to debt service if the payment is financed.
The major alternatives to fixed rate bonds include short-term notes such as floating rate notes and direct bank loans. In today's rate environment, these options are cheaper than fixed rate debt since they keep the coupon low and any pay-fixed swaps can be left in place to hedge the new debt. However, floating rate notes are generally not available to lower-investment grade borrowers, and they present renewal risk in addition to interest rate risk. Bank Qualified loans, a popular alternative in 2010, involve the same risks and may not be an option if the $30 million BQ cap is not extended.
In general, hospitals are well-advised to avoid managing to their ratings. Rating agencies get paid to anticipate risk and analysts like the predictability of fixed rate debt, even if it means higher debt service for borrowers. The certainty of a fixed rate coupon may make life a little easier for everybody, but the coupon itself and the cost of terminating swaps can quickly drain a hospital's liquidity.
Instead of rushing to fixed rate debt, the decision to restructure VRDBs should be the result of a careful evaluation, one that balances cost vs. risk. Stress-testing the capital structure can be an effective tool to estimate the impact of various refinancing options on key financial metrics and credit ratings. Rating agencies do this primarily by projecting LOC term outs and higher interest expense. Hospitals ought to take the analysis to the next level and stress-test the entire balance sheet, debt, swaps and investments. This will facilitate making optimal, risk-adjusted decisions about LOCs coming up for renewal.
Putting the balance sheet through the paces provides additional dividends: by demonstrating that effective financial risk management procedures are in place, the hospital's credit ratings will also benefit.
For hospitals with LOCs expiring in 2011, the time to do this is now.
HFA Partners an independent financial advisory firm whose mission is to help hospitals and other healthcare providers mitigate financial risk, optimize the capital structure and access debt markets on the most favorable terms. For more information, please visit www.hfapartners.com.