Advance refundings involve negative arbitrage or may not be possible under tax law, and waiting for first call date creates interest rate risk. We discuss alternatives that mitigate risk and may be worth considering.
In today’s low interest rate environment, many of the bonds issued by hospitals in the last ten years could be reissued at lower rates for savings.
Savings can be achieved with lower rates and by refunding maturities issued on the long end of the yield curve with shorter, lower-yielding maturities. For a discussion of “rolling down the yield curve”, see When Less Is More: a Look at Partial Refundings.
Unfortunately, most tax-exempt bonds are not callable for the first ten years, so refunding prior to the first call date requires an advance refunding. This presents a challenge since the same low rates that produce savings also cause refunding escrows to generate negative arbitrage.
For example, a 5-year escrow set up today will earn less than 1.5%. If the underlying bonds pay 6%, the negative arbitrage represents 4.5% per year, which is likely to erase any net present value savings.
When an advance refunding is not cost effective or not permitted under tax laws, the common approach is to wait until first call date and do a current refunding. Waiting may improve savings, but it also means taking on Interest rate risk as rates could rise, as well as credit risk as the hospital’s credit quality could deteriorate and investors could demand a higher credit spread.
Alternatives to Advance Refundings
Hospitals who want to lock in savings without an advance refunding and want to minimize interest rate and credit risk have several alternatives. The more effective the alternative is at minimizing risk, the higher the cost, and the lower the net savings to the hospital.
1. MMD Rate Lock
An MMD Rate Lock allows the hospital to lock in today’s MMD rates for a given maturity.
If on bond pricing date, MMD rates have gone up, the hospital receives a payment, which is applied to reduce the par amount of the refunding bonds. If on the other hand rates have fallen, the hospital makes a payment, which can be rolled into the par amount of the refunding bonds. Either way, the resulting debt service remains similar to what it would be today, plus transaction costs.
Because it is based on MMD rates, this structure provides an effective hedge by shifting basis risk to the swap counterparty. Basis risk is the risk that arises from unequal changes in taxable vs. tax-exempt rates.
The MMD Rate Lock’s high cost and short term (typically less than 2 years) limits its value compared to other alternatives.
2. Forward Start, Cash Settle Swap (% of LIBOR)
A forward start, cash settle swap is a form of rate lock achieved via a swap.
The swap mechanics are relatively similar to an MMD rate lock, with the key difference being that the swap is based on LIBOR, which shifts basis risk from the counterparty to the hospital.
Due to basis risk, this structure results in an imperfect hedge, but it is significantly cheaper compared to an MMD rate lock and the forward period can go out much longer. For those reasons, it is generally preferred to the MMD Rate Lock.
3. Forward Delivery Bonds
Forward Delivery Bonds are priced on a given date but not issued and delivered until a future date.
Since the bonds are sold today based on predetermined interest rates, this structure provides an effective hedge against interest rate and credit risk.
However, Forward Delivery Bonds are not generally available for periods longer than 12 months. Also, some underwriters ask for their obligation to take delivery of the bonds to be contingent upon investor performance, which creates additional risk.
4. Forward Bond Option
The Forward Bond Option is similar in concept to Forward Delivery Bonds, but the counterparty (buyer) is sold the option —not the obligation—to buy the refunding bonds at a future date.
In return for this option, the buyer makes an upfront payment to the hospital representing the present value savings of the refunding.
If on call date rates are below the old coupons, the buyer exercises the option to buy the bonds at market rates, and the hospital keeps the upfront payment. If rates are higher than the old coupons, the buyer does not exercise the option and the hospital keeps the upfront payment and the ability to current refund the bonds at a later date.
In addition to the products discussed here, there are other swap-based structures available including caps, floors and collars; they present similar costs and benefits to rate locks.
An advance refunding can also be avoided via a tender offer or secondary market repurchase. This is not usually attractive because bondholders want a premium for parting with bonds that pay higher than market rates, which eliminates savings for the hospital.
Hospitals and their advisors should model net savings for each alternative based on various interest rate scenarios. Modeling credit and basis risk can be tricky, but is equally important when evaluating alternatives that do not hedge these risks. Historical credit and basis spreads can be used in the analysis.
At the end of the day, there is no free lunch: the more effective the structure in mitigating risk, the higher the cost, and the lower the net savings to the hospital.