In ancient societies, the art of reading the internal organs of animals for signs about the future was an important part of a priest’s duties. Had bond markets been around, foretelling future interest rates would have probably ranked up there with wars, crops and strange births.

Of course, the future still cannot be predicted, even today, but being in the business of helping hospitals with their capital structure, we’re still asked the question on a regular basis. In the November 29, 2010 issue of Modern Healthcare in an article entitled “Bond Crisis”, we were given an opportunity to comment on what caused the recent swing in the MMD Index in the first place, with the idea that if we can’t predict the future, at least we ought to be able to explain the past.

Making sense of the past is usually much easier than divining the future. In the last several months, the 30-year AAA MMD Index reached historical lows, then in the course of just two weeks, went from 3.86% to a high of 4.62%. The Build America Bond (BAB) program had unquestionably drained supply out of the traditional municipal bond markets, which many believe caused the steady drop in municipal yields as fund managers grew more and more desperate for tax-exempt paper. This month however, investors must have decided that enough was enough. When municipal borrowers flooded the BAB market, possibly ahead of the end of BAB subsidies, the ensuing rate spike was so pronounced it caused some transactions to be put on hold. Massive investor redemptions had conspired to suck cash from municipal funds, which created a supply-demand imbalance and pushed rates up.

In an environment where rates can go up 70 basis points in two weeks, what can hospitals do to mitigate interest rate risk? For some, a rate cap or collar still provides a suitable hedge, particularly if the need is short-term, for example an upcoming bond issue in the next year. We advise borrowers looking for options to start by quantifying their appetite for risk. The municipal markets are relatively efficient, and risk tolerance often defines the universe of available structures. A thorough review of the balance sheet and proactive approach to identifying and quantifying financial risk helps provide a frame of reference or baseline, which can then be used to evaluate funding scenarios. There are now simulation tools on the market (as a matter of disclosure, we offer one of them) which were previously unavailable to nonprofit healthcare borrowers and help measure interest rate and other risks based on their impact on various key metrics, including liquidity and credit ratings.

There is no magic bullet against interest rate risk: less risk means a higher cost of debt. Healthcare providers may not be able to divine future rates, but with a disciplined approach to looking at their own risk vs. reward equation, they can minimize their risk-adjusted cost of capital and better prepare for what the future may hold.