The House proposal to end tax-exempt debt and the upcoming Senate bill to change corporate tax rates are wreaking havoc in the municipal debt markets. As emails from bond underwriters and lawyers exhort hospitals to rush and beat the December 31 deadline, we discuss what CFO’s should be doing instead.
The Tax Cuts and Jobs Act introduced in the House on November 2 is causing mass hysteria in the municipal finance world.
If passed in its current form, the bill would prevent not for profit hospitals and other 501(c)(3)’s from issuing tax-exempt debt after December 31.
The House bill also proposes to end tax-exempt advance refundings.
If the bill drags on into 2018, most bond counsels will be unlikely to give a clean tax opinion past that point unless the deadline is postponed or the bill withdrawn, so it is plausible that tax-exempt bond issuance stops after the first of next year.
The second concern is the bill expected to be introduced in the Senate this week to reduce the corporate income tax rate.
Corporate tax reform scares muni markets because corporate investors (banks and insurance companies) make up 25% of existing tax-exempt muni bonds holdings.
If the Senate bill succeeds in lowering the corporate tax rate from 35% to 20%, the after-tax yield investors receive on municipal bonds becomes less attractive compared to taxable yields.
For example, the lower corporate tax rate would cause a 4% yield to be worth 100 basis points less; corporate investors would ask for higher yields, making borrowing more expensive for hospitals.
If corporate tax rates change, bank placements would become an immediate problem for hospitals because they usually contain language that gives the lender the right to increase rates in response to changes in tax regimes.
It’s unclear as to how corporate tax reform would affect overall tax-exempt rates, because the changes would only affect one-fourth of total demand, but it would likely be a measurable increase in rates, particularly with bank placements.
Given the cumulative threat of the two bills, should hospitals rush to market and sell bonds to beat the December 31 deadline?
We think not.
Unless the hospital has already started the process, closing a public bond offering in such a short amount of time would be painful, and could result in unattractive terms.
Also, making a decision based on proposed legislation could be detrimental by limiting options if the final legislation varies from what was proposed, as it almost always does.
What we think makes more sense right now is for hospitals and their municipal advisors to evaluate their current debt portfolio and their future needs regardless of whether the outcome means another bond offering and more fees for underwriters, or not.
Hospitals should know where they stand with their existing debt, and have a plan in place for future access to the debt markets:
- Existing debt: tax risk can be identified and quantified, paying particular attention to tax language in bank placements and other non-traditional debt instruments. Language that provides a clear and reasonable adjustment and/or the option to prepay without a punitive penalty is preferable.
- Future debt: hospitals should revisit their capital plan timing and evaluate structural options. Taxable bonds are not new and have grown in popularity among hospital borrowers, some preferring it to the complications of issuing and monitoring tax-exempt debt. Depending on the hospital’s specific needs, alternative structures may also be available.
The glut of panicky emails and calls is likely to continue and may cause some folks to rush to market.
But hospitals are no strangers to legislative uncertainty, and instead, this should be a time for cooler heads to prevail.