Recently enacted legislation affects corporate tax rates and, as a result, the cost of capital for not-for-profit healthcare borrowers. Kaufman, Hall & Associates, LLC is publishing a series of bulletins related to the capital structure implications of this new law; this bulletin focuses on options that may be employed in lieu of advance refunding outstanding debt. As with each of our bulletins, we encourage our readers to consult with bond and tax counsel before making any final determinations about these approaches.
The Tax Law’s Effect on Advance Refundings
For not-for-profit healthcare borrowers, a highly significant aspect of the Tax Cuts and Jobs Act of 2017 is the elimination of advance refundings on a tax-exempt basis. Long used as a method of lowering the capital cost for debt issued in higher interest rate environments, not-for-profit healthcare organizations now will need to consider alternative, less-efficient methods to refinance their bonds prior to 90 days before the call date.
Healthcare organizations use advance refundings for a variety of reasons. The primary use has been to lower the cost of capital by refinancing existing bonds in a lower rate environment for economic savings. Additionally, advance refundings have been used to remove various financial covenants, restate Master Trust Indentures (as part of consolidation activity or independently), release Debt Service Reserve Fund monies, and/or enhance or restructure debt service for flexibility.
Although the most common and often least costly method of advance refunding debt—via the issuance of tax- exempt refunding bonds—is no longer an option, multiple strategies can achieve largely similar results. Each of these strategies ultimately changes one or more core characteristics of the organization’s debt position, so each methodology should be considered carefully. For example, advance refunding tax-exempt bonds with taxable debt may accomplish the benefits outlined above, but a taxable bond often has a make-whole call feature that would preclude the organization from refunding the new bonds for economic savings in the future. Therefore, we have tried to enumerate the differences below as we describe both bond-related and derivative strategies.
Bond-Related Strategies
An effort has begun to limit the amount of time borrowers need to wait before current refunding their bonds. Begin with the premise that eliminating advance refundings prevents refunding a bond more than 90 days before its call date—in our industry a 10-year call. Since the end of 2017, we have begun to see borrowers and investment banks evaluating the impact of various shorter call structures ranging from five to seven years on new issues.
Fundamentally, the organization purchases this optionality from investors, so they pay a higher cost for a shorter call. Our observation thus far is that the premium paid for a shorter call has not been worth the cost, especially if the new bonds remain outstanding for any period of time beyond their call date. We expect pricing for shorter call structures to evolve over time.
In the aftermath of the new tax law, the most common method to pursue advance refundings likely will be by issuing public taxable fixed-rate bonds to maturity. Taxable fixed-rate bonds carry many of the features of tax-exempt fixed- rate bonds, though without the yield restriction and arbitrage rebate rules. Additionally, assets financed by taxable bonds would no longer carry the burden of federal tax code limitations regarding allowable ownership and use. As previously mentioned, however, public taxable fixed-rate bonds frequently have different structural features, including bullet maturities, par couponing, and make-whole call features.
Although these differences exist, public fixed-rate bonds still allow organizations to lock in interest rates for refunding bonds to final maturity without incurring various forms of additional risk (for example, bank renewal, price, put, counterparty). This important feature differentiates taxable advance refundings from the other strategies and tactics described below.
As an alternative, borrowers may elect to issue short-term taxable bonds that mature (or become callable) within 90 days of the original bond’s call date. The new taxable refunding bonds are subsequently refunded on a current basis by tax-exempt bonds. Once the new issue matures or becomes callable, the borrower issues tax-exempt current refunding bonds at then current interest rates. This method locks in savings until the original bond’s call date, but the borrower is exposed to interest rate risk for its tax-exempt refunding opportunity until the tax-exempt current refunding issue prices. This risk is noteworthy in a generally rising rate environment.
Less common bond-related alternatives also exist:
- Organizations may elect to run a formal Tender or Bond Exchange program as a means of effectively seeking investor consent to replace higher coupon debt with a more economic bond. However, these methods can be difficult to put into effect and rely on the willingness of investors to participate.
- We have also been involved in discussion about convertible taxable/tax-exempt debt or “Cinderella Bonds,” which are initially issued as taxable debt but subsequently convert to tax-exempt bonds at a predetermined rate at the borrower’s election. Although this solution would appear to be an elegant fix because interest rates for both periods are established at pricing and therefore locked to maturity, the premium that investors charge for the conversion feature is currently expensive, and investor interest is limited.
- A number of investment banks have discussed the use of Forward Delivery Bonds, in which the new obligation is priced with a delivery date sometime in the future and coordinated with the call date of the refunded issue. In this way, Forward Delivery Bonds remove interest rate risk while waiting for the call date, but at a significant premium to a standard bond transaction. Additionally, demand for these obligations can be limited depending on the investment bank and investor willingness to extend the settlement date for any significant period of time.
Derivative Strategies
Swap-related alternatives also exist, but they carry additional layers of risk. Organizations can hedge components of interest rate risk while waiting for the call date using MMD rate locks or one of several derivative alternatives (LIBOR swap, SIFMA swap, US Treasury Rate Lock, etc.). These approaches vary in terms of cost, tenor, and effectiveness, but they can help in certain circumstances.
Entering into a Forward Starting floating-to-fixed swap contract in advance of the call date allows the borrower to lock in interest rates beginning on the prior bonds’ call date to its maturity (via swap) in expectation that floating rate refunding debt will subsequently be issued at the call date. When entering into this type of contract, tax-exempt variable-rate current refunding bonds are issued on the call date when the swap cash flows begin. This approach is referred to as a forward-starting current refunding. Risks associated with this approach include those associated with any swap transaction (for example, counterparty, collateral posting, basis, mark-to-market), as well as the risk that a borrower will not be able to issue variable rate debt at the time when the swap cash flows are expected to begin on the prior bonds’ call date. This would leave the borrower “overhedged.”
A variation on swaps would be to use a Swap Option or “Swaption” strategy, wherein the borrower buys or sells the right to enter into a swap contract similar to the one mentioned above at a pre-determined point in time (i.e., the call date). If the option is sold by the borrower, then the Counterparty has the right to exercise the option and the borrower should assume that the option will be exercised and that variable rate refunding bonds will need to be issued in the future.
If the borrower purchases the option, then they control the exercise decision at the call date and have effectively “capped” the economic downside to the amount of the up-front option premium. The primary considerations in this type of contract are the size of the payment to be made/received and whether option control is retained (purchased) or transferred (sold). Swaption contracts carry various risks, including interest rate risk and counterparty risk and should be vetted with your bond counsel and financial advisor prior to execution.
Evaluating Your Options
As with any capital structure decision, each of the options we have described should be rigorously analyzed and its implications studied as they apply to each hospital’s situation. Various factors influence the decision of whether a solution is suitable for the organization, including technical factors such as investor demand, tax-exempt supply, and taxable/tax-exempt ratios, as well as broader concerns about legislative risk and interest rate risk.
Options are available to meet refunding needs; however, each comes with some level of differentiation relative to the organization’s current capital structure. Methods will continue to evolve. We recommend that any alternatives should be discussed with each organization’s financial advisor.