Comparing the cost of funds between debt structures can be challenging, particularly with public bond offerings. To make it easier, hospitals must understand coupon, yield, credit spread, and how to approach premium bonds.
Coupon vs. Yield
Coupon is the interest rate used to determine interest payments.
Yield measures the rate of return on all cash flows including net proceeds and future debt service payments.
Because it takes into account all cash flows, yield is considered a more accurate measure of the all-in cost of funds.
Yield can vary significantly from coupon in the case of premium or discount bonds.
A premium bond is a bond sold for more than its par (face) value, whereas a discount bond is sold at less than par.
Premium bonds provide investors with interest rate protection because the higher the coupon, the less the bond price will decline when rates rise.
Calculating yield gets more complicated when bonds feature an optional call provision, which gives the borrower the option to prepay the bonds before they become due.
If a premium bond is called early, the investor (who paid a higher price initially in return for the expectation of higher coupons) won’t be receiving all of these coupons after all, so the yield to the call date is lower than if the bonds were held to maturity.
With premium bonds, yield to call is always lower than yield to maturity.
Because yield to call is a worst case scenario for investors, it has become industry convention to use it instead of yield to maturity when discussing premium bonds.
The worst case scenario for a borrower is when the premium bond is held to maturity, because yield to maturity may end up significantly higher than yield to call.
In a rising interest rate environment, a premium bond is less likely to be called early since rates have more of chance of rising than falling, so a refunding may not create any savings.
For that reason, using yield to maturity when evaluating premium bonds is considered a more conservative approach to estimating a borrower’s all-in cost of debt.
Yield on debt put in place on different dates is usually not directly comparable, as interest rates may have changed.
To adjust for changes in interest rates and allow apples-to-apples when comparing yields, the bond markets use credit spread.
Credit spread is the premium investors receive over a high quality index in return for taking on a borrower’s repayment risk.
By minimizing credit spread, the hospital can minimize its cost of debt.
In the tax-exempt bond markets, credit spread is calculated as the difference between a bond’s yield and the “AAA” Municipal Market Data index for that same maturity.
For example, a 30-year bond with a yield of 4.00% implies a 1.00% credit spread if the 30-year AAA MMD is 3.00%.
Credit spreads vary based on the borrower’s credit profile, structure, maturities, and interest rate levels:
- Borrower credit profile: the higher the borrower’s credit quality, the lower the credit spread. Credit quality is generally reflected in bond ratings (S&P, Moody or Fitch).
- Structure: tax preference, state of issuance, call provisions, covenants, security.
- Maturities: the longer the maturity, the higher the credit spread. For example, a 30-year facility will carry a higher credit spread than a 5-year facility. This reflects the investor’s higher risk exposure from lending over a longer time period. It is therefore critical when comparing credit spreads to use similar maturities. A common practice among underwriters is to measure spreads based on the longest maturity. This can be misleading when comparing bond issues with different maturities, so spreads should be measured taking into account all maturities, something underwriters generally do not bother with.
- Interest Rate Levels: in today’s very low interest rates, spreads are compressed and the difference between a good and a so-so credit is minimal.
With a basic understanding of yield, coupon and credit spread, hospitals and their financial advisors can make better decisions when evaluating different debt structures and minimizing the cost of funds.
- Minimizing Credit Spreads and the Hospital’s Cost of Debt (HFMA Strategic Financial Planning 1/22/2014)
- A Better Way to Track the Hospital’s Cost of Debt (9/16/2013)
- The Hidden Cost of Premium Bonds (3/28/2013)