The following is reprinted with permission from HFA Partners.
In spite of today's low fixed rates, hospitals continue to borrow in variable-rate mode. While new debt structures have eliminated some of the risks and can offer a lower cost of funds, the ability to capture savings with variable-rate debt in an uncertain interest rate environment requires a long-term approach.
Historical trends
Historical rates for the past 20 years show some interesting trends:
• Short-term rates are consistently lower than long-term rates. Except for a handful of very brief spikes, the SIFMA weekly reset index traded well below the MMD 20-year "Aaa" index. Currently, SIFMA is about 250 basis points lower than the MMD.
• Over 20 years, SIFMA averaged 2.5 percent, about 50 basis points below the current MMD (April 2012).
• For periods of less than 20 years, SIFMA at times traded significantly above the 20-year average (1995 to 2001 and again in 2006 to 2009).
Predicting the future can be hazardous, but based on historical rates, a hospital borrowing variable rate today can:
• Save 250 basis points, if rates stay at current levels.
• Expect to save 50 basis points versus MMD if SIFMA returns to the historical average over the long run.
• Expect less savings — or even dissavings — over shorter time periods.
Variable-rate debt and credit spreads
Fifty basis points a year doesn't leave much of a safety cushion, but there is more to variable-rate debt than indexes.
Whether borrowing SIFMA, percentage of Libor or MMD, all hospitals pay a credit spread to compensate investors for taking on the borrower's credit risk. Variable-rate structures currently offer lower spreads than public offerings (the preferred structure for fixed-rate borrowing). In the public bond markets, spreads are consistent across maturities, as MMD already compensates investors for tenor: The 30-year MMD is normally higher than the 10-year MMD.
With variable-rate debt, however, SIFMA does not compensate lenders for term risk, so the longer the term, the higher the spread the bank needs to charge. All else held equal, bank facilities have a shorter term than fixed-rate bonds, so they carry a lower spread. It also helps that banks have more detailed information, better analytics, and right now, are aggressively courting hospital deposits and other business.
A "BBB+" hospital borrowing variable for 7 to 10 years can negotiate savings as much as 50 basis points over a fixed-rate public offering. So now we're looking at total expected savings of 100 basis points.
New bank structures are less risky
Traditional variable-rate debt presents risk, but bank direct placements have effectively reduced or eliminated its two most significant components:
• With a letter of credit, bonds put back to the hospital must be either remarketed or paid in full before the LOC expires. Bank direct placements are not remarketed, so the bank cannot put them back.
• Bank placements go out longer than LOCs (up to 10 years or more), which allows for more amortization, so it reduces renewal/refinancing risk.
Tax and credit risk remain in bank placements. Tax risk is the possibility that changes in the tax code makes tax-exempt indexes more expensive. Credit risk is the risk that the hospital has to pay a higher credit spread if downgraded. Fixed-rate bonds transfer these risks to bondholders, but not so with LOC-backed bonds or direct placements.
Finding the proper mix
Variable-rate debt creates risk not found in fixed-rate debt, so too much of it can negatively impact a hospital's financial position and bond ratings. When deciding on the right mix of fixed- and variable-rate debt, it sometimes comes down to board preferences, but rating agencies can also provide a few insights:
• Moody's Investors Service expects the median hospital to keep twice as much cash and unrestricted investments on hand as put debt, so it can be paid off in a hurry.
• Moody's also reported last year that the median mix of put debt to total debt was 18 percent, but this ratio varies greatly depending on credit quality: "Aa" providers are heavy users with 41 percent in put debt, while "Baa" providers are more conservative with only 8 percent.
There is a strong correlation between cash on hand and ratings, so it makes sense that higher-rated borrowers have more cash and capacity for put debt.
Rating agencies are not as helpful with bank direct placements and other forms of non-puttable debt. Moody's said it considers more than 70 percent debt in variable-rate mode (before swaps) as an "analytical red flag," but that was when LOC-backed debt was the only way to go. Still, 70 percent is more than most hospitals would tolerate today for any type of variable rate debt, put or non-put.
To get more accurate feedback from rating agencies, the best option may be to have an informal discussion with an analyst or pay for a private rating. In either case, it's best to have a specific scenario — rating agencies get nervous about anything that could be interpreted as dispensing financial advice.
Conclusion
Is the opportunity to save an average of 1 percent enough for hospitals to take on the risks found in variable-rate debt? Many standalone hospitals don't think so, but most larger, highly-rated health systems do. In spite of today's very low fixed rates, over the long run, the proper type and amount of variable-rate debt can still be expected to provide a cost advantage and keep risk at a manageable level.
HFA Partners is an independent financial advisory firm helping hospitals and healthcare providers lower the cost of debt and reduce balance sheet risk.
In spite of today's low fixed rates, hospitals continue to borrow in variable-rate mode. While new debt structures have eliminated some of the risks and can offer a lower cost of funds, the ability to capture savings with variable-rate debt in an uncertain interest rate environment requires a long-term approach.
Historical trends
Historical rates for the past 20 years show some interesting trends:
• Short-term rates are consistently lower than long-term rates. Except for a handful of very brief spikes, the SIFMA weekly reset index traded well below the MMD 20-year "Aaa" index. Currently, SIFMA is about 250 basis points lower than the MMD.
• Over 20 years, SIFMA averaged 2.5 percent, about 50 basis points below the current MMD (April 2012).
• For periods of less than 20 years, SIFMA at times traded significantly above the 20-year average (1995 to 2001 and again in 2006 to 2009).
Predicting the future can be hazardous, but based on historical rates, a hospital borrowing variable rate today can:
• Save 250 basis points, if rates stay at current levels.
• Expect to save 50 basis points versus MMD if SIFMA returns to the historical average over the long run.
• Expect less savings — or even dissavings — over shorter time periods.
Variable-rate debt and credit spreads
Fifty basis points a year doesn't leave much of a safety cushion, but there is more to variable-rate debt than indexes.
Whether borrowing SIFMA, percentage of Libor or MMD, all hospitals pay a credit spread to compensate investors for taking on the borrower's credit risk. Variable-rate structures currently offer lower spreads than public offerings (the preferred structure for fixed-rate borrowing). In the public bond markets, spreads are consistent across maturities, as MMD already compensates investors for tenor: The 30-year MMD is normally higher than the 10-year MMD.
With variable-rate debt, however, SIFMA does not compensate lenders for term risk, so the longer the term, the higher the spread the bank needs to charge. All else held equal, bank facilities have a shorter term than fixed-rate bonds, so they carry a lower spread. It also helps that banks have more detailed information, better analytics, and right now, are aggressively courting hospital deposits and other business.
A "BBB+" hospital borrowing variable for 7 to 10 years can negotiate savings as much as 50 basis points over a fixed-rate public offering. So now we're looking at total expected savings of 100 basis points.
New bank structures are less risky
Traditional variable-rate debt presents risk, but bank direct placements have effectively reduced or eliminated its two most significant components:
• With a letter of credit, bonds put back to the hospital must be either remarketed or paid in full before the LOC expires. Bank direct placements are not remarketed, so the bank cannot put them back.
• Bank placements go out longer than LOCs (up to 10 years or more), which allows for more amortization, so it reduces renewal/refinancing risk.
Tax and credit risk remain in bank placements. Tax risk is the possibility that changes in the tax code makes tax-exempt indexes more expensive. Credit risk is the risk that the hospital has to pay a higher credit spread if downgraded. Fixed-rate bonds transfer these risks to bondholders, but not so with LOC-backed bonds or direct placements.
Finding the proper mix
Variable-rate debt creates risk not found in fixed-rate debt, so too much of it can negatively impact a hospital's financial position and bond ratings. When deciding on the right mix of fixed- and variable-rate debt, it sometimes comes down to board preferences, but rating agencies can also provide a few insights:
• Moody's Investors Service expects the median hospital to keep twice as much cash and unrestricted investments on hand as put debt, so it can be paid off in a hurry.
• Moody's also reported last year that the median mix of put debt to total debt was 18 percent, but this ratio varies greatly depending on credit quality: "Aa" providers are heavy users with 41 percent in put debt, while "Baa" providers are more conservative with only 8 percent.
There is a strong correlation between cash on hand and ratings, so it makes sense that higher-rated borrowers have more cash and capacity for put debt.
Rating agencies are not as helpful with bank direct placements and other forms of non-puttable debt. Moody's said it considers more than 70 percent debt in variable-rate mode (before swaps) as an "analytical red flag," but that was when LOC-backed debt was the only way to go. Still, 70 percent is more than most hospitals would tolerate today for any type of variable rate debt, put or non-put.
To get more accurate feedback from rating agencies, the best option may be to have an informal discussion with an analyst or pay for a private rating. In either case, it's best to have a specific scenario — rating agencies get nervous about anything that could be interpreted as dispensing financial advice.
Conclusion
Is the opportunity to save an average of 1 percent enough for hospitals to take on the risks found in variable-rate debt? Many standalone hospitals don't think so, but most larger, highly-rated health systems do. In spite of today's very low fixed rates, over the long run, the proper type and amount of variable-rate debt can still be expected to provide a cost advantage and keep risk at a manageable level.
HFA Partners is an independent financial advisory firm helping hospitals and healthcare providers lower the cost of debt and reduce balance sheet risk.
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