As tax reform threatens to take tax exempt debt away from hospitals and municipal markets predict the imminent collapse of the healthcare sector, we compare taxable and tax exempt debt and conclude that for most hospitals, these concerns may be overblown.
The tax bill introduced in the House earlier this month would eliminate advance refundings and private activity bonds. The Senate bill would also take away advance refundings, but would preserve private activity bonds.
Advance refundings can generate savings, but they don’t have much effect on the average hospital’s cost of funds. If anything, eliminating them would limit supply as there would be fewer bonds outstanding, which would help keep rates low. Hospitals could still use swaps to lock in savings until a current refunding is permitted.
The elimination of private activity bonds is more of a concern because for hospitals and other not for profit borrowers, these bonds are the only way to tap the tax-exempt debt markets. Take away private activity bonds, and the only remaining option is taxable debt.
The loss of tax exempt funding would increase the cost of funds and for some hospitals, may prevent access to debt altogether.
There’s no question that taxable rates are higher than tax exempt rates, making taxable debt less affordable. In today’s low rate environment, the gap is relatively small. According to a recent Bond Buyer article, the average spread between the Bloomberg Barclays Taxable Municipal Bond Index and the Bloomberg Barclays Municipal Bond Index from November 2016 through October 2017 was 126 basis points (1.26%). The spread can be much higher depending on credit quality, coupon, maturity, issue size, and other factors including name recognition.
If private activity bonds are left alone but the Senate bill succeeds in lowering the corporate tax rate from 35% to 20%, the after-tax yield investors receive on tax exempt bonds becomes less attractive compared to taxable yields, which would cause investors to ask for higher yields, making tax exempt borrowing more expensive for hospitals.
In spite of the higher cost, some hospitals have already decided to go taxable because of the benefits including lower upfront costs, quick time to closing (particularly if sold without a conduit issuer or as a bank loan), and less ongoing regulatory burden.
To quantify the additional cost of taxable debt, it helps to look at actual financings. Following are four hospital deals that went to market in the last 90 days and featured both a taxable and a tax exempt component.
After adjusting for differences in redemption feature, the taxable yield was 27 to 116 basis points more than the tax exempt yield for the corresponding maturity. The gap is likely to be wider when looking at borrowers below investment grade.
The next logical question is how does this higher cost of funds affects the financial picture, particularly for weaker hospitals.
In the short term, the impact is modest. According to Moody’s, the average non-investment grade hospital has $150 million in outstanding debt and $29 million in cash flow to cover the associated $12 million in annual debt service. Assuming the hospital replaces one-third of that existing debt ($50 million) with taxable debt at an extra 2% (the AHA’s estimate in a letter sent to the House Ways and Means Committee), the incremental $1 million in annual debt service would cause debt service coverage to fall from 2.4 times to 2.2 times, hardly a threat to financial stability, although a borrower with thinner coverage could be much closer to an event of default.
It does get worse over time as tax exempt debt is amortized and replaced with taxable debt so the burden from the additional interest grows. We would expect some hospitals would respond in the same way as they did in high interest rate environments: shorten maturities to take advantage of the current yield curve, with the 10-year Treasury rate currently about 40 to 50 bps lower than the 30-year rate; some would also increase their mix of variable rate debt to benefit from the 1-month Libor being about 200 basis points lower than the 30-year Treasury rate.
Banks may pick up business due to their affinity for smaller, Libor-denominated loans with shorter maturities and the lack of diversification in the public markets, where demand from corporate investors is concentrated among large issues and highly rated borrowers. Bond funds and insurance companies prefer taxable issues greater than $300 million, where index eligibility can be worth 25 basis points or more in yield. In comparison, the average hospital tax-exempt bond issue size in 2016 was $87 million in the BBB category, and a puny $42 million in the non-investment grade category.
In addition to deal size limitations, taxable investors don’t have the same research capabilities as their tax exempt brethren, so they gravitate to highly-rated household names. This puts smaller hospitals at the lower of the credit spectrum at a disadvantage, which means higher rates or even being shut out of the public markets for some.
Our crystal ball is not better than others, but while the loss of tax exemption would not help the average hospital, it’s hard to see how it would represent an immediate and devastating blow for all but the most financially-challenged hospitals.
Over time, demand from corporate investors for taxable muni bonds would probably improve across issue sizes and credit quality. Investors may also warm up to 10-year calls. However, financial pressure would mount as hospitals amortize tax exempt debt and replace it with taxable coupons. A rise in rates would add to this burden by widening the gap between taxable and tax exempt rates.
The average hospital will survive tax reform, but smaller providers may not fare as well.