As the U.S. economy continues to struggle, short-term interest rates have settled at historic lows and may remain that way as the Federal Open Market Committee has signaled its intention to keep short-term interest rates low through mid-2013. As a result, now may be an opportune time for hospitals to finance a new project or refinance existing debt with a variable-rate interest structure.
The one-month LIBOR (London Interbank Offered Rate) rate and SIFMA (Securities Industry and Financial Markets Association) indices are the taxable and tax-exempt benchmarks for financing debt with short-term rates.
At the time of writing this article, the one-month LIBOR rate is 0.23 percent. This rate is used to price floating-rate notes and variable-rate mortgages. The SIFMA index, currently at 0.15 percent, is used in remarketing tax-exempt variable-rate demand bonds (VRDB). Both rates have fallen significantly since 2008.
Borrowers can take advantage of the low short-term interest rates by utilizing short- and intermediate-term financing structures, such as VRDBs enhanced with letters of credit (LOC) from banks, FHLB (Federal Home Loan Banks) LOCs and index notes. The appropriate structure depends on the project, credit attributes of the borrower, and comfort with the financing terms and inherent risks.
LOC-Backed Variable-Rate Demand Bonds
A LOC-backed VRDB structures provides access to short-term variable interest rates using a bank’s credit rating instead of the borrower’s. A remarketing agent sets the interest rate based on current market levels, often using the SIFMA index as the benchmark. VRDBs have consistently provided the lowest cost of capital, and this structure remains attractive in today’s interest rate environment.
During 2006 and 2007, LOCs were often obtained for fees less than 1.00 percent of the par amount of the bonds. However, the cost of LOC’s increased dramatically after the 2008 financial crisis. Recently, LOC pricing has improved and stronger borrowers may be able to obtain an LOC in the 1.50 percent range.
Benefits to LOC-Backed VRDBs include: (1) a cost effective, credit enhanced structure; (2) they allow ready access to the bond market; and (3) benchmark interest rates are currently at historically low levels.
FHLBs are rated AA+ and are used to enhance taxable-debt issuances when a member bank provides the LOC. Therefore, local banks may provide organizations access to investment-grade credit, similar to traditional LOCs from larger banks.
Although an FHLB can only enhance taxable debt, nonprofit organizations should still consider FHLB LOCs because in today’s unique market, taxable financings often provide a lower cost of capital than tax-exempt structures. Also, taxable bonds require fewer upfront closing costs with fewer restrictions on the use of bond proceeds.
The FHLB LOC wrap is one option for a non-rated or low-investment grade borrower who is unable to obtain a traditional LOC. The par amount will be limited by the local banks’ capacity to lend, so debt offerings totaling more than $15 million or so may be more difficult for one bank to underwrite.
In the case of a larger project, the borrower may create a syndicate of local banks, so long as the banks are willing to take a parity security position in the collateral.
Benefits to FHLB LOC wraps include: (1) a cost effective, credit enhanced structure; and (2) the LOC fee stays local.
The index floater has been a long available, but often overlooked, financing structure. Like the LOC wrap, an index floater is most affordable to investment-grade borrowers. However, this structure is also available for near investment-grade and unrated borrowers.
The index floater is a multi-modal VRDB with an initial index-floater mode or period (typically three years) during which the bond pays an interest rate equal to a short-term index plus a fixed credit spread, which is similar to what the LOC fee would have been on a LOC-backed VRDB.
The bond can be sold through a public offering or privately placed directly with a bank and is subject to a one-time mandatory tender at the end of the initial period, at which time the bond can be remarketed to any other mode available under the indenture. The index floater’s interest rate resets periodically (often monthly or quarterly, but could also reset weekly, semiannually or annually).
Benefits to index floaters include: (1) they avoid LOC and remarketing fees; and (2) multimodal flexibility helps keeps interest rates low, while providing flexibility after the mandatory tender.
In today’s interest rate environment, short-term variable-rate financings may provide a lower cost of capital solution when compared to long-term fixed-rate structures. If short-term interest rates remain low, the debt-service savings can generate significant cash flow savings for the organization.
Timing is everything when funding debt with short-term rates. Working with an investment banker or financial advisor, a borrower can determine the proper capital structure mix of fixed-rate and variable-rate debt.
Aaron Becker is a vice president for Lancaster Pollard, a provider of debt financing and investment advisory services for hospitals nationwide.
