Determining the appropriate level of variable-rate exposure requires careful consideration of:
An organization’s credit profile
The size of the organization
The ability to generate profits/cashProfitability and cash flow
The organization’s existing capital portfolio
Industry trends and implied level of risk
Its overall risk tolerance
Variable-rate debt is still appealing because it allows for better matching of assets with variable-rate liabilities and enables the organization to manage the risk associated with interest rate volatility.
H2C INDUSTRY INSIGHTS • CAPITAL MARKETS
Strategies in Capital Finance:
October 31, 2019
By Katie E. Proux, William B. Hanlon III and Victoria S. Poindexter
An organization’s long-term viability requires that its return on assets exceeds its cost of capital. In the asset-intensive, highly regulated, increasingly challenging and competitive healthcare delivery market, where return on assets can be low and often volatile, managing the cost of capital is a critical component of long-term success.
Not-for-profit healthcare systems have traditionally capitalized their businesses largely with tax-exempt debt, and over the last several decades, long-term interest rates in the tax-exempt bond market have generally trended downward. This combination of high debt capitalization and declining interest rates has resulted in a steadily declining cost of capital, enabling a corresponding decline in the threshold for return on assets. A lower cost of capital allows healthcare organizations the opportunity for greater reinvestment in core assets and a higher tolerance for tighter operating margins without sacrificing sustainability.
At any given point during the past 30 years, variable-rate debt has been less expensive than fixed-rate debt (see the Exhibit 1 below). Hindsight suggests that heavily overweighting the short-term market would have resulted in the lowest cost of capital, although the trade-off for this low cost has been volatility of cash flows and event risk for borrowers.
More recently, while variable rates have risen, fixed rates remain historically low—and many borrowers believe now is the time to lock in a significant portion of their cost of capital by using long-term, fixed rates to their advantage. Issuing fixed-rate debt offers borrowers a long-term financing solution in the form of committed capital with predictable cash flow requirements at a reasonable price. At the same time, however, maintaining some level of variable-rate debt is considered a basic building block of a fully diversified debt portfolio. Healthcare organizations managing the cost of capital must use their own subjective criteria to determine the appropriate balance of fixed and variable interest rate exposure.
Historically, Variable-Rate Debt Has Proved Less Expensive than Fixed-Rate Debt
Source: Thomsen Reuters TM3, SIFMA.
Why Variable-Rate Debt Is Appealing—Even in a Low Fixed-Rate Environment
With no shortage of volatility over the past decade, it’s easy to see why many tax-exempt issuers have shied away from variable-rate debt. After all, why issue variable-rate debt if the only certainties are uncertainty and risk?
Not surprisingly, the public issuance of variable rate debt declined significantly after the 2008 financial crisis. This was due in part to the deterioration of third-party credit support, which was often included with the most well-known type of publicly offered variable-rate bonds: variable-rate demand bonds (“VRDBs”). While the popularity of some products decreased as a result of the financial crisis, others ceased to exist entirely. The auction rate securities market completely failed as investors pulled their money, leaving limited to no liquidity to support the auctions. Borrowers were burned with high default rates, and previously healthy risk appetites became significantly less ravenous. Other headline events that impacted the variable-rate debt market and continue to influence its evolution include tax reform, interest-rate volatility, and the implementation of international financial guidelines (Basel agreements).
Over the next several years, healthcare borrowers moved toward more fixed-rate debt in anticipation of rising interest rates—and their assumptions proved right. When the Federal Reserve raised rates a quarter-point to 2.5 percent in December 2017, it was the fourth increase that year and the ninth consecutive rate hike since 2015.
Recently, however, we’ve seen a sharp decline in interest rates. During the July 2019 meeting of the Federal Reserve, officials voted to decrease the Fed Funds target rate for the first time since the 2008 recession. Now, experts anticipate at least two more rate cuts of 0.25 percent each before the end of the year, with the next cut expected in September.
In this environment, fixed-rate debt offers extremely attractive long-term pricing for healthcare organizations, while variable-rate debt presents healthcare organizations with the lowest cost of capital. These conditions are expected to continue through 2019.
While tax-exempt, fixed-rate debt continues to be the preferred financing mechanism by not-for-profit healthcare borrowers, in recent years, more issuers have demonstrated renewed interest in variable-rate debt due to its low cost and the variety of structures available. Low-cost debt is especially attractive at a time when providers are feeling the squeeze of rising drug costs, shrinking reimbursement, declining inpatient admissions, and greater cost-shifting to consumers by employers and health plans. Margins are decreasing: Moody’s Investors Service found the operating cash flow margin for not-for-profit and public hospitals fell to a 10-year low last year as revenue pressures continue to outpace cost-containment initiatives.
Frequently, however, the lowest-cost option is often accompanied by additional risks, which are important to understand in the context of an organization’s operating projections, competitive market environment, debt policy, and prevailing market trends. For variable-rate debt, these risks include exposure to interest-rate volatility and remarketing or refinancing risk. The introduction of the Secured Overnight Financing Rate (SOFR), the proposed alternative to LIBOR, has created yet more uncertainty: How will SOFR trade relative to LIBOR? Will LIBOR continue to exist after 2021, and if so, how will the reformed LIBOR trade?
Managing the Risks of Variable-Rate Debt
The absence of advance refundings is prompting more hospitals and health systems to explore alternatives to fixed-rate debt. Given that most bonds are callable within 10 years, organizations that issued tax-exempt bonds in 2010, when interest rates were higher, may wish to plan their refinancing strategy now. For some organizations, variable-rate debt products may prove to be an attractive alternative.
What are the benefits and risks of each variable-rate debt product—and how do the products compare with one another? Following are examples of the most common products available.
Benefits and Considerations of Variable-Rate Debt Products
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For ease of reference, a comparison of the most common variable-rate debt products and typical characteristics is included (Exhibit 3). A detailed explanation of variable-rate debt products is located in the sidebar.
What type of borrower is best served by each product? Following are examples of borrowers by product.
Self-Liquidity VRDBs—Organizations that qualify for self-liquidity VRDBs are characterized by the strongest liquidity metrics, consistent operating performance, and high credit ratings (Aa3/AA- or better). They are typically larger systems.
VRDBs with Standby Bond Purchase Agreements/Letters of Credit—Third-party support for borrowers interested in diversifying and achieving low cost of capital. Typically, issuers are rated below Aa3/AA- and/or manage a balance sheet that would materially suffer in the event the put option is exercised.
FRNs—Typically issued by investment grade-rated borrowers prioritizing low cost of capital and that are comfortable with remarketing risk at the end of tenor.
Commercial Paper—Employed by the largest and highest-rated credits that need access to short-term financing.
R-Floats—Typically used by borrowers with consistent operating performance that are interested in low-cost, long-term debt, but that may need the extra-long remarketing period.
Window VRDBs—Issued by large credits with healthy balance sheets that are known by the public market. Window VRDBs are an alternative to VRDBs, so the issuer profile is similar.
ARS—Offered access to low-cost, variable-rate debt for issuers of varying credit strengths without the need for bank credit support. Including bond insurance on ARS products enabled lower-rated credits that did not have access to VRDBs to participate in the variable-rate market.
Determining the Right Debt Mix
In theory, the ideal debt profile will result in the lowest risk-adjusted cost of capital as measured at any point in time. What was considered ideal three or four years ago might not be ideal today, as rates fluctuate, and organizations’ strategies evolve over time. Debt management is a dynamic process that is most effective when regularly evaluated and adjusted against market movements, future capital plans, operating performance, and credit strategy. Establishing a debt policy or set of internal guidelines that addresses target debt levels and risk tolerance will help ensure consistent debt management practices regardless of the environment.
The best debt product is not necessarily the one with the most competitive rates, but rather the one that fits the organization’s risk tolerance and can be structured to meet the borrower’s individual needs. Ultimately, each healthcare organization must carefully consider its risk appetite in determining whether to issue variable-rate debt—and how much. Weighing the benefits and risks of each product available is a good exercise for any borrower before committing to variable rate or more conventional long-term fixed rate debt.
For further information and guidance on variable-rate debt products, please contact us.
Comparing the 4 Most Common Variable-Rate Products
Taking a Closer Look:
7 Variable-Rate Products
Variable Rate Demand Bonds (VRDBs)
Most common structure today for variable-rate public debt.
Allows borrower to secure financing at attractive short-term rate when borrowing over long term.
Interest rate is most often reset weekly or daily by a remarketing agent.
Rate is often pegged to SIFMA.
Investors may put their bonds on any interest rate reset date.
Borrowers may call the bonds on any interest payment date.
Credit Support: letters of credit (LOCs), standby bond purchase agreements (SBPAs), or self-liquidity provide investors with assurance that their puts will be honored.
Keep in mind: Interest rate must be low enough to compensate the borrower for accepting the risk of redemption, but high enough to provide an incentive for investors to purchase the bonds.
Variable-Rate Direct-Purchase Bonds
Direct-purchase bonds may be structured as tax-exempt or taxable bonds or loans.
Most like bank loans as they are not publicly offered and are based on a private agreement between the borrower and bank.
Depending on the size of the borrowing, one bank typically buys the entire bond series or advances the full loan amount.
If the borrower is interest, the lender often proves willing to negotiate the refinancing rate at the mandatory tender date (usually 5-, 7-, or 10-year term).
Keep in mind: Banks will frequently offer more competitive pricing if the borrower agrees to ancillary non-credit business relationships (e.g. lines of credit, deposits, money market accounts).
Floating-Rate Notes (FRNs)
Attractive, short-term rates at a spread that is locked in for a specific tenor—typically three to five years—at issuance.
Like VRDBs, FRNs are most often priced based on SIFMA plus a spread.
Borrower is exposed to remarketing risk at the conclusion of the tenor.
No daily or weekly put risk as there is with VRDBs.
Limited investor base relative to VRDBs.
Unsecured debt issued at a discount that is often used to meet short-term liabilities.
Only the largest health systems with the strongest balance sheets access this market.
Typically matures within 270 days of issuance but is often rolled over into a new issue at maturity.
Alternatives to Self-Liquidity VRDBs (R-Floats / Term Floaters / Windows)
Can be outstanding for 20 to 30 years without changing terms.
No credit facility required; however, the spread is not locked-in as it is with FRNs.
Good alternative for borrowers with “A” ratings or lower, interested in self-liquidity VRDB’s, but lack the credit strength.
In case of a failed remarketing, the bondholder cannot put the bonds back to the issuer for at least two years.
Recent pricing data indicates that R-Floats are highly competitive relative to direct bank loans.
Investor pool is quite shallow, which introduces another degree of risk.
Less common structure issued by not-for-profit healthcare borrowers.
Auction rate securities (ARS)
Developed in the 1980s to reduce the borrower’s cost of capital in a high-interest-rate environment.
No longer issued today, but for decades, ARS offered low variable-rate prices without the need for bank credit facilities.
Originally intended as a structure for stronger credits, the use of bond insurance expanded the universe of prospective auction-rate borrowers.
ARS used a reverse auction process to set the interest rate on the securities, whereby the lowest rate that cleared the market was applied to all bonds until the next auction date.
Auctions began failing with the financial collapse in 2008, leaving many borrowers saddled with high default rates for extended periods.
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For further information and guidance on variable-rate debt products, please contact one of our Capital Markets professionals.