When planning debt issuance, hospitals and other borrowers try to anticipate the direction of interest rates, but they should also pay attention to credit spreads. In the last several years, spreads have not only declined but also compressed, which has cut borrowing costs and made rating upgrades less valuable.
Credit spread is the additional yield that investors receive on top of a risk-free yield in exchange for taking on repayment risk. In the municipal bond markets, the risk-free yield is usually the Municipal Market Data (MMD) 30-year “AAA” General Obligation yield. Credit spread is measured in basis points (0.01%).
Because credit spreads tend to vary by maturity, bond traders often use the spread for the longest maturity, aka the “long bond”, as proxy for an issue’s total credit spread. The problem with this approach is that ignoring other maturities can distort the analysis, particularly when comparing issues with different amortization schedules. Recognizing the need for a better way to track credit spreads, we developed a formula a while back which captures the present value of spreads across all maturities. Unlike the long bond approach, this formula permits a direct comparison of bond issues with different maturities. For more on True Spread, see A Better Way to Track the Hospital’s Cost of Debt.
Following the 2008 financial crisis which witnessed the Lehman bankruptcy and the collapse of bond insurers and auction rate securities, credit spreads soared for all rating categories. They have since declined and have remained relatively consistent since 2014, although they are up slightly since the November election.
Our first chart shows hospital credit spreads by rating category. Each category includes three ratings, for example, the BBB category includes BBB-, BBB and BBB+. Average spreads for each category since 2008 are shown as dotted lines.
One takeaway from the chart is that investor concerns about healthcare reform have not (yet) translated into higher credit spreads. That is likely because there aren’t enough hospital bonds to meet investor demand, which keeps spreads low, but things may change as the fate of the ACA becomes clearer. Meanwhile, the lack of supply means cheap debt for hospitals, even for those at the lower end of the investment grade spectrum. The next chart shows the all-in cost of debt by adding credit spreads to the 30-year MMD.
Another takeaway is the growing trend of spread compression over the last several years as the difference in spreads between rating categories has gotten smaller. Historically, spreads tend to compress as rates decline.
Spread compression is important because it means less value in a bond rating. Our next chart takes a closer look at credit spreads for each rating notch, instead of looking at rating categories.
Of particular interest to hospitals is how flat the 2016 curve is, because the flatter the curve, the less valuable the rating. There isn’t yet enough data in 2017 to be statistically significant, but in 2016, the average difference in spread between rating notches was a mere 13 basis points, the lowest of the last 10 years. This means that the impact of a single-notch upgrade or downgrade on a hospital’s cost of funds is the smallest it’s been since the 2008 financial crisis.
For a $50 million issue, 13 basis points is only worth about $1 million (present value) and that’s assuming the bonds are outstanding for the entire 30 years instead of being called early. The dollar cost will go up as the issue size increases and will also vary depending on the rating. In 2016, the difference between a BBB- and a BBB credit was 28 bps, whereas it was only 4 bps between a BBB+ and A-.
Of course, a hospital may have to live with its rating for a long time and if spreads change, so will the cost of a lost rating in future bond offerings, but for now, it’s minimal.
As previously mentioned, there are signs that credit spreads are on the rise in 2017, which could make borrowing more costly for hospitals even if interest rates stay at their current levels.