The fees underwriters charge to sell hospital bonds have declined over the last several years. Lower costs of issuance help keep the cost of debt down, but hospital CFOs should keep in mind it’s only one piece of the hospital’s cost of funds equation.
When it comes to borrowing, nobody likes to overpay; what is “market” for underwriting hospital bonds is one of the most frequent questions asked of financial advisors.
Knowing how much to pay can be problematic for hospitals, particularly those who have relied on bank placements and may not have hired an underwriter in several years.
But with a basic understanding of the dynamics behind underwriting fees and recent changes in the bond markets, chief financial officers are in good position to negotiate with underwriters to keep the cost of funds low.
How Underwriting Fees Are Set
Fees paid to underwriters are based on a percentage of the issue size or par amount and are often discussed as underwriter’s discount or underwriter’s spread.
Fees are the commissions and profit the underwriter realizes by buying the bonds at below their offering price and reselling them to investors at the offering price.
Spread is quoted in dollars or points per thousand dollars of par, so a $5 spread (aka 5 points) on a $50 million offering represents a fee of $250,000.
Underwriter’s fees are the single largest cost of issuance; other costs include legal fees, financial advisor, rating agencies, trustee, and printing costs.
For tax-exempt bonds issued by non-profit hospitals, total costs of issuance are generally capped per IRS rules to 2% of par.
Chief financial officers need to know that municipal underwriting spreads have steadily declined across all sectors in the last number of years, including healthcare.
According to Thomson Reuters, the average spread for all negotiated municipal bonds was $13 in 1986. In 2013, it was down to $5.
In the last five years alone, the average underwriting spread for hospital bonds went from $8 to $6, a 25% decline.
This trend has affected hospitals across the entire credit spectrum, from BBB to AA.
The major factor behind lower spreads appears to be supply and demand.
2014 was the slowest year for healthcare bond issuance since 2001.
Fewer deals means more competition among underwriters struggling to maintain market share.
Underwriters laid off some bankers, but many are still around chasing business.
Fee pressure has been heightened by the emergence of bank placements which do not require underwriters and generally involve lower costs of issuance.
It doesn’t help investment banks that interest rate swaps have also gone out of favor during the same period.
In their heydays, swaps represented about 70% of Wall Street public finance revenues.
With underwriting as their sole source of revenue, bankers are chasing fewer deals and hospitals are in improved position to negotiate lower underwriting fees.
Underwriting Spreads by Deal Size
Hospitals are often told by underwriters to borrow as much as possible in order to spread fixed costs of issuance over a larger amount of proceeds, with a goal to lower the hospital’s all-in cost of funds.
However, the evidence shows that underwriting fees —the largest component of issuance costs—do not decline materially as a percentage of par beyond the $25 to $50 million mark.
Bond Issue Size
Higher-rated hospitals are selling bigger offerings while lower-rated hospitals have cut back on issue size.
The median bond issue par amount for BBB hospitals declined from $86 million in 2010 to $52 million in 2014, while AA size went from $120 million to $160 million in 2014.
The median issue size for A hospitals has remained relatively constant at around $80 million.
Underwriting Spread Variability
Underwriting spreads can vary significantly from deal to deal, particularly in the lower investment grade sector where deals are less frequent and credit pictures more complex.
As a result, BBB category hospitals can expect to see proposed spreads vary more widely among underwriters than their A and AA counterparts.
Negotiating underwriting fees is relatively straight forward and can be negotiated on the front end as part of the underwriter’s selection process.
But yields are not known with certainty until pricing day.
An underwriter’s track record and ability to achieve aggressive yields on day of pricing can have a much longer lasting impact on the hospitals’ cost of debt than underwriting fees.
Oftentimes, financial advisors are expected to create the most value by helping negotiate lower underwriting spreads, when in fact, greater savings can be realized by helping minimize yields on day of pricing.
A mere 20 basis points reduction in yield on a $50 million bond issue creates present value (PV) savings almost 10 times greater than a 20 basis points reduction in the underwriter’s spread.
Negotiating underwriting fees is always a good idea, particularly for lower investment grade hospitals that are being charged more by underwriters for selling their bonds.
But selecting an underwriter who can sell bonds at aggressive yields can have a much larger impact on the hospital’s cost of funds.