With the MMD near record lows, more hospitals are revisiting refundings. Before rushing to market, hospital CFOs ought to examine their options to determine if a partial refunding could boost savings and if a public offering is the best plan of action.
Refundings generate savings by reducing interest expense. There is no hard and fast rule on setting the bar for target savings, but most hospitals and other not-for-profit borrowers aim for minimum net present value (NPV) savings of 3 to 5% of par amount.
NPV savings is calculated by discounting debt service savings using the arbitrage yield, which is the internal rate of return (IRR) at which debt service equals par amount net of issue premiums or discounts.
Most bonds sold ten years ago are now currently callable. If not, they can be advance-refunded. However, in today’s interest rate environment, an advance refunding is generally unfavorable to savings, as escrow earnings will not cover the debt service on the bonds during the escrow period.
Refundings cut interest expense in two ways: by taking advantage of a general decline in interest rates, and by “rolling down the yield curve”.
Decline in Interest Rates
The first and most common way a refunding achieves savings is when rates have gone down since initial issuance.
Unfortunately for hospitals, while benchmark rates such as the MMD (Municipal Market Data) index have declined, credit spreads have soared to record highs as investors demand a higher premium for assuming credit risk.
The MMD has shed about 180 basis points (1.8%) since early 2002, but after adding credit spreads, hospital coupons are only about 60 basis points (0.6%) lower for “BBB” category hospitals, and about 110 basis points (1.1%) lower for “A” category hospitals.
Rolling Down the Yield Curve
The second way to generate refunding savings is to “roll down the yield curve” by replacing long maturities (issued near the top of the yield curve) with shorter maturities (issued near the bottom of the yield curve). By moving down the yield curve, the hospital pays a lower coupon even if the interest environment hasn’t changed.
The chart below demonstrates the benefits of rolling 10 years by replacing a seasoned 20-year maturity (10 years remaining) with a new 10-year maturity. The old maturity carried a “BBB” yield of 5.8%. It is refunded with a new 10-year term bond at a 4.0% yield. The coupon is cut by 180 basis points. Without rolling, the savings would be half.
In today’s rate environment, rolling down the yield curve also generates attractive savings for hospitals in the “A” category.
A partial refunding replaces selected maturities while leaving others in place, and is permitted by most bond documents. Historically, partial refundings were often done to address structural constraints, but in today’s steep yield curve, they can be effective at generating savings by zeroing in on specific maturities (see green area in chart).
Coupon savings alone do not necessarily translate into NPV savings. Therefore, a “maturity-by-maturity” refunding analysis factoring in costs of issuance and present value can help determine which portion of the bonds to refinance in order to maximize savings.
The maturity-by-maturity analysis may involve a large number of variables and is often performed by an experienced financial advisor who can also assist with the overall refunding process.
Public Offering vs. Direct Placement
Until a couple of years ago, most refundings (full and partial) were sold as public offerings through a bond underwriter. With the rise of bank direct placements, hospitals now have the option of selling the bonds to a bank via a limited offering. For an overview of bank direct placements, read our article “The Pros and Cons of Bank Direct Placements” in HFMA Strategic Financial Planning Fall 2011.
By structuring the direct placement to refund maturities in the 10 to 20-year range with maturities of 10 years or less, the hospital rolls down the yield curve and realizes a majority of the potential savings, yet stays within the maximum final maturity of around 10 years required by most banks.
A partial refunding allows the hospital to realize the benefits of a bank direct placement; namely, lower costs than a traditional public offering. A placement eliminates bond underwriter fees, the largest component of transaction costs. In addition, a bank placement does not have a debt service reserve fund (DSRF). If the refunded bonds had a DSRF, it may be released. If they didn’t, a bank placement does not need one whereas a public offering does, which affects savings.
Placements present other opportunities for savings, including lower rating agency fees; although at least one of the agencies is charging rated borrowers for reviewing placements –whether or not the placement itself will be rated.
Bank direct placements have one inherent limitation in that they are typically priced at Libor plus a spread, so a swap may be required for the hospital to achieve a fixed coupon. For some hospitals, a swap is not an option. Public offerings on the other hand offer a “straight” fixed rate without a swap.
Placements also involve additional terms and balance sheet risk. In general, hospitals should keep in mind that placements are negotiated instruments and unlike public offerings, their terms tend to vary greatly between borrowers. As limited offerings, placements are not subject to the same disclosure requirements as public offerings. This makes market terms quite difficult to ascertain without a competitive solicitation process. Oftentimes, hospitals that elect not to go the competitive route end up with unfavorable terms.
Hospitals presented with refunding opportunities should carefully review all structural options. Depending on the situation, a partial refunding may produce greater savings by accessing a different portion of the yield curve, and a bank placement may enhance savings by minimizing transaction costs. The ultimate decision should balance savings and non-economic considerations, including balance sheet risk.
This article was reproduced in the HFMA Strategic Financial Planning newsletter online edition published in April 2012.