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.