Taxable Bonds: A Timely Structure

Tax-exempt, fixed-rate bonds were nearly always the go-to choice for providing nonprofit organizations one of the most cost efficient methods of accessing debt. It used to be a foregone conclusion and a slam-dunk decision by hospital leadership. But that, of course, was before the Great Recession and at a time when healthcare reform was considered a distant possibility.

Today, more hospitals are looking at taxable financing structures, such as taxable bonds and FHA mortgage insurance. And it's not just hospitals that are joining for-profit businesses in issuing taxable debt. According to The Bond Buyer, more nonprofit entities, including local governments and universities, as well as healthcare providers, are using taxable issuances to refund tax-exempts this year. 

Tax exempt, the traditional choice 
Tax-exempt or tax-free bonds for nonprofit hospitals are still a favorite option for capital, but the structuring of that debt requires a strategic approach. Hospitals can issue bonds publicly based on their credit profile by selling bonds to retail and institutional investors or offer bonds on a private placement basis to banks and other financial institutions.

As long-term debt goes, fixed-rate, tax-exempt municipal bonds are the most common method of accessing capital for hospitals. Knowing what debt service will be paid for a specific period of time offers hospitals the comfort of stability. Typically, these bonds provide issuers with an attractive cost of capital and limited risk, which can offset the required issuance fees. They are generally accessible to hospitals and health systems of all ratings and sizes-a borrower just needs to be willing to pay the cost of debt based on its particular credit profile. In general, there is a strong appetite among investors for municipal issuances. 

On the other hand, there are three primary limitations of fixed-rate, tax-exempt bonds that hospital leaders need to consider carefully: 

• Higher transaction costs, including set fees for issuance, underwriting and compliance, which can increase a borrower’s cost of capital because of the upfront closing requirements.
• More restrictions about what's eligible to be funded as qualified tax-exempt purposes, which results in more regulation and greater IRS scrutiny.
• Investor call protection, a defined prepayment schedule for investors, can prevent the issuer from forcing early redemption despite market improvements that could lead to refinancing opportunities.

Tax-exempt, variable-rate demand bonds are attractive to borrowers because they offer a lower cost of capital and contain more flexible call features. However, VRDBs have inherent risks, including interest rate risk, put risk and remarketing risk, and should be considered very carefully by hospital leadership. Since the nation's near financial collapse in 2007, VRDB volume has decreased, primarily because of the reduced supply of bank-backed letters of credit to enhance the structure.

Opportunities in taxable bonds 
In the first half of 2013 taxable municipal issuances increased 90 percent from $12.77 billion to $24.23 billion, according to The Bond Buyer’s 2013 in Statistics: Midyear Review. The number of taxable deals rose from 551 to 715. Of the top 25 largest bond sales in the first half, 14 had taxable components and 10 of the 14 were refundings. In healthcare, the volume of taxable issues was nearly $774 million, more than twice the amount when compared to the same period in 2012. 

Taxable debt, as the name implies, is subject to taxes from the bond investor's standpoint. These bonds use different benchmark indices than tax-exempt bonds and typically return a higher rate as opposed to the lower return rate offered by tax-exempt bonds. Characteristically, the taxable bond market is larger and more liquid than municipal tax-exempt bond market.

One reason for the appeal of taxable debt is the favorable rates currently offered in the municipal marketplace. The extended period of low interest rates has narrowed the gap between tax-exempt and taxable issues. Taxable debt today is much less expensive than it was in the halcyon days before the Great Recession. Additionally, there are more opportunities for investors this year as taxables offer good incremental yield without incrementally increasing risk plus an opportunity to diversify their portfolios. More issuances have generated greater interest among buyers creating a more robust market that has not been seen since the end of the Build America Bond program, according to The Bond Buyer.

Another, just as persuasive, argument for taxable bonds is that hospitals typically have less restrictions and more flexibility than with traditional tax-exempt bonds. The use of proceeds from these bonds can be used for any corporate purpose, such as:

• Building or acquiring medical office buildings.
• Installing IT systems, for example an electronic health record system.
• Using for operational costs, such as starting and running an accountable care organization or purchasing a physician group.

As seen in the examples, hospitals are free to use the funds for strategic initiatives that might not qualify for tax exemptions. Going with taxable rather than tax-exempt bonds could lead to less federal regulation and oversight from the IRS. In addition, no issuing authority is needed, which means that with fewer approvals and fees, the cost of issuance can be less expensive. Although publically offered taxable issuances require the same disclosure as tax-exempt offerings, the specified use of proceeds can be less specific. For example, the offering statement can state the use of bond proceeds will be for "general" purposes.

Finally, the speed to execution of a taxable issuance can be faster and less burdensome than a tax-exempt offering due to fewer restraints. Additionally, offering the issuance to a broader investor base as opposed to only limited investors interested in a tax exemption can lead to more efficient bond pricing and distribution. For many hospitals, timing is essential to obtain the desired interest rate as well as the funding to begin capital projects when needed.  

However, before thinking taxables are the way to go if interest rates are low, hospital leaders should consider the following factors when deciding the best funding option to use:  

• Borrowers must pay investors the expected interest payments through maturity. This means the bonds are either noncallable or have "make-whole" provisions which limit refinancing opportunities for the borrower.
• Most taxable issuances are $50 million and up, with the average being around $200 million. This can limit taxable issuances to larger hospitals and health systems and to those with high investment grade ratings.

Taxable bonds in action
To provide you some insight by example, these hospitals and health systems chose to issue taxable bonds:

• Recently, Catholic Health Initiatives, a Colorado nonprofit, issued $540 million in taxable fixed rate paper, with $275 million in five-year bonds at 2.5 percent interest rate and $265 million in 10-year bonds at 4.3 percent interest rate.  The issuance was rated A1 by Moody’s Investor Services with a negative outlook and an A+ with a stable outlook by both Standard & Poor’s and Fitch Ratings. The uses for the bond proceeds include project reimbursement, refunding indebtedness, acquisitions and cost of issuance. 
  
  
• Boston’s Tufts Medical Center sold $25,602,000 in taxable fixed-rate bonds for 10 years at 5.4 percent, $14,398,000 for 15 years at 6.3 percent and $60,000,000 for 25 years at 7 percent. It was rated BBB by both S&P and Fitch. The official statement lists the use for general corporate purposes, including, but not limited to, acquisition of or affiliation with large medical groups and development of new clinical services. 
  
  
• Elmhurst Memorial Hospital, in Elmhurst, Ill., offered more than $76 million in taxable fixed rate refunding bonds, which were rated Baa2 by Moody’s and BBB by Fitch. Although not the norm for taxables, the bonds were issued by Illinois Finance Authority for a five-year term at 4.45 percent.
  
  
• Earlier this year, Seattle’s Virginia Mason Medical Center issued more than $136 million in fixed rate taxable bonds at 5.1 percent for 31 years, which were rated Baa2 by Moody’s and BBB by S&P. The offering memorandum stated that the proceeds were for general corporate purposes, including financing the costs of constructing a medical office building. 
  
  

Currently, with the negligible gap in interest rates as compared to tax-exempts, taxable bonds can be a cheaper and more flexible way for larger nonprofit hospitals and health systems to finance their growth strategies.  While the attractive interest rates associated with taxable offerings might not last forever, the expanded use of proceeds and speed of execution provide additional incentives for hospital leadership to explore taxable bond issues as they continued to implement elements of the Patient Protection and Affordable Care Act. 

Matt Lindsay is a vice president with Lancaster Pollard. He is regional manager for the Pacific Northwest and is based out of Columbus. He may be reached at mlindsay@lancasterpollard.com.