Taxable rates have become attractive, in part due to the low interest rate environment, but also because banks are getting more aggressive and tax-exempt debt simply isn’t what it used to be.
Remember the old story about the patient needing a heart transplant and having to choose between two donors: a 26 year-old marathon runner, and a 62 year-old IRS agent. He picked the agent’s heart, since it was never used. But IRS hearts, particularly those from agents who audit tax-exempt debt, may soon be harder to find. More not-for-profit borrowers are looking at bank loans over traditional tax-exempt bonds, and they like what they see.
Low Interest Rates Have Squeezed The Tax Advantage
Appallingly low variable rates have caused the difference between taxable and tax-exempt coupons to shrink. Last week, the tax-exempt SIFMA 7-day reset index hit a low of 0.09%. While SIFMA looks dirt cheap at less than half of the taxable 30-Day Libor (0.19%), both indexes are so low that the difference between the two is puny: less than $3,500 a month on $50 million of debt.
Tax Exemption and Deductibility Has Changed
The gap between taxable and tax-exempt debt coupons has been further reduced by the end of the $30 million cap on bank qualified (BQ) debt, and by questions about the value of tax deductions for some banks. With BQ debt, banks were allowed to take 80% of their cost of capital as an expense. The benefit was passed on to borrowers in various percentages, and could sometime reduce pricing by 40 or 50 bp (as a side note, BQ direct placements have become a popular alternative to LOC-backed VRDNs, but can also involve risk as discussed in S&P Report: The Appeal Of Alternative Financing). Not only is the BQ program back to the old cap at the issuer level, making it unavailable to most borrowers, but for some banks, the value of the deductibility of interest income has become questionable and thus more difficult to pass on to borrowers.
Banks Are Pricing Credit Risk More Aggressively
Another contributing factor to low taxable rates is how banks, the major suppliers of hospital taxable debt, are pricing credit risk. Currently, banks require a lower premium or “credit spread” over benchmark rates than investors who buy publicly-offered hospital bonds. In some cases, we have seen bank credit spreads coming in at half the public bond spreads. With indexes at historical lows, the credit spread has become a much larger component of all-in pricing, which further narrows the gap between the taxable and tax-exempt costs of funds.
Fixed Rates Have Joined The Party
The impact of low variable taxable rates has also carried over to fixed rates, and we’re seeing banks offering fixed rate loans at very small premiums or even discounts over comparable tax-exempt structures, and do so without requiring the hospital to carry a swap. Consider a BBB+ hospital looking for a 7-year taxable loan with a 25-year amortization (some banks will go out 10 years and longer depending on credit). A motivated bank may quote a taxable fixed coupon of 3.50%, whereas in the traditional tax-exempt bond markets, a tax-exempt coupon for a similar maturity would be closer to 4.00%.
How Long Will Taxable Coupons Stay Low?
As rates climb back to historical averages, taxable debt will become more expensive relative to tax-exempt debt, unless of course the current tax reform efforts end tax exemption altogether. This won’t affect hospitals who lock in today’s taxable rates for the duration of the loan. It won’t be much of a factor with variable rate debt either, because most bank loans can be prepaid at any time, so hospitals who borrow taxable on a variable rate basis can refinance with tax-exempt fixed-rate debt as the tax advantage grows larger with rising rates. While prepayment of a bank facility is often subject to a “make whole” provision based on Libor breakage and redeployment costs, in a rising rate environment, this payment ought to be minimal since the bank can make a new loan to somebody else at a higher rate. As with all financial instruments, it pays to carefully review all documents and make sure terms are fully understood.
Given the lack of bank appetite for renewing hospital letters of credit, taxable bank debt may be an alternative to tax-exempt financing worth considering.