The Implications of Losing Access to Tax-Exempt Financing

On January 17, 2025, a list of potential cost reductions to the federal budget was released by Republicans on the House Budget Committee. The list is long and covers the federal budget waterfront, but it spends considerable time focusing on reductions to healthcare spending. This laundry list of cost reductions is important because the highest priority of the Trump administration is a further reduction in federal taxes. A reduction in taxes would, of course, reduce federal revenue; if federal expenses are not proportionately reduced then the federal deficit will increase. When the deficit increases then the federal debt must increase and at that point the overall impact on the American economy becomes concerning and possibly damaging. There has already been much public speculation as to how the Federal Reserve might react to such a scenario.

It is not possible right now to highlight and describe all of the House budget proposals, but one proposal absolutely stands out: The suggestion to eliminate the tax-exempt status for interest payments on all municipal bonds, or potentially in a more targeted manner, for private activity bonds, including those issued by not-for-profit hospitals. Siebert Williams Shank, an investment banking firm, described the elimination of tax exemption for municipal bonds as “the most alarming of the proposed reforms impacting non-profit and municipal issuers.”^[1] This is certainly true for hospitals, since over the past 60 years the growth and capability of America’s hospitals has been substantially constructed on the foundation of flexible and relatively inexpensive tax-exempt debt. Given all of this, it is not too early to begin speculating on the impact of the elimination of tax-exempt debt on hospital finances and strategy.

We should also point out that a separate topic is under discussion, related to the potential loss of not-for-profit status for hospitals and health systems. Such a maneuver could potentially expose hospitals to income taxes, property taxes, and higher funding costs. For now, that is beyond the scope of this blog but may be something we write about in future posts.

Below is a series of important questions related to the elimination of tax-exempt financing and some speculations on the overall impact:

1. What immediately happens if 501(c)(3) hospitals lose the ability to issue tax-exempt bonds? Let’s treat fixed rate debt first. Assume for now that only newly issued debt would be affected and that all currently outstanding tax-exempt fixed rate debt would remain tax-exempt. We could see an effort to apply any changes retroactively to existing bonds, but we view that as unlikely. Therefore, our current expectation is that outstanding fixed-rate debt would not see a change in interest expense.
   
   However, it is possible that outstanding floating rate debt would immediately begin to trade based on the taxable equivalent. Historically the tax-exempt floating rate index trades at about 65% of the taxable index. The difference between the tax-exempt and taxable floating rate indices in the current market is 175 basis points. For every $100 million of debt, this would increase interest expense by $1.75m annually.
2. How would new hospital debt be issued? New debt would be issued in the municipal market on a taxable basis or in the corporate taxable market. The taxable municipal market would need to adapt and expand to accommodate a significant level of new issuance. The concern in the corporate taxable market is greater. Currently, the corporate market requires issuance of significant dollar size and generally the issuer brings significant name recognition to the market. Many hospitals may have difficulty meeting the issuance size of the corporate debt market and/or the necessary market recognition. As such, smaller and less frequent issuers would expect to pay a penalty of 25-50 basis points for issuing in the corporate market.
3. If tax-exempt debt goes away will certain hospitals be advantaged and others disadvantaged? Larger hospitals with national or regional name recognition that issue bonds with sufficiently large transaction size and frequency will likely borrow at better terms and lower rates. Smaller- to medium-sized hospitals may find borrowing much more difficult, and borrowing may come with more problematic terms and/or amortization schedules and likely higher interest rates.
4. Will borrowing costs go up? The cost of funds for new borrowings would increase for all hospital borrowers. For a typical A-rated hospital, annual interest expense would increase by approximately 30%. For example, in the current market, on $100 million of new debt, average annual interest expense would increase by $815,000 annually.
5. Will debt capacity go down? All other things being equal, interest rates will go up and hospital debt capacity will go down. Also, if the taxable market shortens amortization schedules, then that will decrease overall debt capacity as well.
6. What would the impact of the elimination of tax-exempt debt be on synthetic fixed rate structures? Hospitals have long employed derivative structures to hedge interest rate risk on outstanding variable rate bonds and loans. The loss of tax-exemption for outstanding variable rate bonds and loans would precipitate an adjustment to taxable rates, but corresponding swap cash flows are not designed to adjust. Interest rate risk is hedged, but tax reform risk is not. The net effect to borrowers would be an increase in cost similar to the cost contemplated above for variable rate bonds.
7. What are the rating implications of the elimination of the tax-exempt market? Rating implications will be varied. Hospitals with strong financial performance and liquidity are likely to absorb the increased interest expense of a taxable borrowing with little to no rating impact. In fact, over the past decade, many larger health systems in the AA rating categories have successfully issued debt in the taxable market without rating implications despite a higher borrowing rate. Even amid the pandemic chaos of 2021, numerous AA and A rated systems issued sizable, taxable debt offerings to bolster liquidity as proceeds were for general corporate purposes and not restricted by a third-party, such as a bond trustee.
   
   Lower-rated hospitals with modest performance and below-average liquidity will be at greater risk for a downgrade. These hospitals may not be able to absorb the increased interest expense and maintain their ratings. While interest expense is typically a small percentage of a hospital’s total expenses, it is a use of cash flow.
   
   We do not anticipate the rating agencies will take wholesale downgrade action on the rated portfolio as there would likely be a phase-in period before the elimination occurs. Rather, we expect the rating agencies will take a measured approach with a case-by-case evaluation of each rated organization through the normal course of surveillance, as they did during the pandemic and liquidity crisis in 2008. A dialogue on capital budgets and funding sources, typically held at the end of a rating meeting, would be moved to the top of the agenda, as it will have a direct impact on long-term viability.
8. How would the loss of the tax-exempt market impact the pace of consolidation in the hospital industry? If a hospital cannot afford the taxable market, then large capital projects would need to be funded through cash and operations. This inevitably will limit organizational liquidity, which will lead to downward rating pressure. Some hospitals, in such a situation, will be unable to both fund capital and adequately serve their local community and, therefore, will need to find a partner who can. We anticipate that the loss of the tax-exempt bond market will lead to further consolidation in the industry.

Let’s indulge in one last bit of speculation. What is the probability that Congress will pass legislation that eliminates tax-exempt financing? Sources in Washington tell us that it is premature to wager on any of the items put forth by the Budget Committee. And it should be noted that over the years the elimination of tax-exempt financing has been proposed on several occasions and never advanced in Congress. However, one well-informed source noted that as the tax and related legislation moves forward, there is likely to be significant horse-trading (especially in the House) to secure the necessary votes to pass the entire package. What happens during that horse-trading process is anybody’s guess. So the best advice to our hospital readership right now is to not take anything for granted. But be absolutely assured that the maintenance of tax-exempt financing is an essential strategic component for the successful future of America’s hospitals.

[1] Siebert Williams Shank, “Not-for-Profit Healthcare Update—Proposed Federal Budget Reforms,” Jan. 23, 2025.