Tax-exempt rates have risen since the Fed announced QE3 last Thursday, offsetting a significant drop in the MMD and hospital credit spreads over the last several weeks. But hospitals looking to refund debt can still win if they set realistic target savings.
In A Nutshell…
- In the last few months, hospital credit spreads have compressed more than 30 bps
- Low credit spreads and low MMD rates have made refundings more attractive
- Since last Thursday however, MMD rates jumped 20 bps, cutting into savings
- To play it safe, hospitals need to set realistic target savings.
In the tax-exempt bond markets, hospital coupons consist of a risk-free index, and a credit spread or premium. For fixed-rate bonds, the risk-free index is the Municipal Market Data or “MMD” index, a composite of high-quality general obligation bond yields. MMD yields vary by maturity, with longer terms carrying a higher yield. In spite of a 20 basis point (0.20%) jump since the Fed announcement last week, MMD yields are still trading at historical lows. The other component of fixed-rate bond pricing is credit spread. This spread is the premium bondholders require on top of the MMD for taking on a specific hospital’s credit risk. The more risk, the higher the spread. Spreads are directly related to bond ratings. Unlike the MMD, spreads tend to stay relatively consistent across maturities.
Credit spreads have become compressed over the last few weeks, most noticeably at the lower end of the investment grade spectrum: the BBB and lower A categories. In early 2012, the average BBB category hospital could expect to sell debt at a spread of at least 200 basis points to the MMD. Recently, the BBB spread has dropped to an average of 170 basis points. On a $50 million bond issue, the savings can easily exceed $2 million over 10 years. Keep in mind that spreads are market-driven and may vary significantly between borrowers, even in the same rating category.
Since it can take a lot of time and effort to line up a public bond offering, and since there is no guarantee that the refunding will be “in the money” on pricing day, hospitals need to do what they can to avoid wasting time pursuing a refunding. It can be very frustrating –not to mention politically uncomfortable– for management to watch the MMD climb and savings evaporate by the time the hospital is ready to price.
Nobody can predict the course of interest rates, but there are a couple of ways to mitigate interest rate risk. The first approach is to lock in current rates with a hedge. There are some problems with hedging: it costs money, and a lock is basically a swap, aka a four-letter word for many hospital boards. The second and more conventional approach is to move forward with refunding plans, but with some target savings. If at any time estimated savings fall below the target, bond underwriters are told to go play golf until the savings pick up. The target can be either formal (parameters resolution), or informal. The actual number can be a dollar net present value savings, or a percentage of savings vs. refunded debt. For many hospitals, the minimum net present value savings is 5% of refunded debt.
Regardless of the formula or the actual number, in a volatile interest rate environment, it is imperative to build enough cushion to absorb a potential rise in rates and/or credit spreads, particularly if the bonds won’t sell for some time. If target savings are set at 5% and the hospital embarks upon the refunding with savings at 5.01%, it won’t take much from Ben Bernanke to miss the target –the hospital may want to consider lower target savings.
In setting target savings, hospitals can also take into account other factors, including the opportunity to remove a debt service reserve fund or restrictive bond insurer covenants, improve debt service coverage by “layering” annual debt service, or even lower the cost of issuing new money debt by combining it with the refunding.
Interest rates and credit spreads will fluctuate. The Fed will print more money. Investors will go in and out of the tax-exempt markets. In today’s volatile interest rate environment, setting realistic expectations is key to preserving flexibility and to maintaining sound financial risk management practices.