Minimizing credit spread is a simple process with bank debt, but it is much more challenging for publicly-offered bonds. 

 

When it comes to debt, obtaining the lowest possible rate is every borrower’s goal, and health providers with capital-intensive projects are no exception. But in the public debt markets, selling bonds to investors at competitive rates requires a basic understanding of the pricing process and the ability to accurately measure credit spreads. 

Determining Credit Spread

Credit spread is the additional yield over a high-quality index that investors require for taking on a borrower’s repayment risk. By adjusting for changes in interest rates, credit spreads facilitate pricing comparisons between different bond issues. The lower the credit spread, the lower the cost of debt.

For fixed-rate bonds, the index of choice is the AAA municipal market data (MMD) yield in effect on the day the bonds priced. The MMD is published daily for maturities ranging from one to 30 years. In today’s environment, hospital credit spreads range from less than 100 basis points (1 percent) for the AA category to 200 basis points and higher for the BBB and below category (see the exhibit below).

Anatomy of a Credit Spread

While credit spreads vary primarily based on a borrower's credit quality, they also act as a catch-all for other factors affecting a bondholder’s ROI: 

  • Maturities: Shorter maturities carry lower credit spreads. 
    • This spread curve is the most significant challenge borrowers must face when comparing bond issues side by side since spreads should always be compared between like-maturities. 
     
  • Other factors: Spreads can be affected by state of issuance, tax preference, and structure, including first call date, covenants, and security. 

Minimizing Credit Spread

With bank debt, credit spreads are usually disclosed in proposals, and loans rely on a single spread. The spread can be based on the Libor rate for variable-rate loans or the Libor Swap rate for fixed-rate loans. Knowing the credit spread proposed by each bank, the hospital simply picks the proposal with the lowest spread. 

With public offerings on the other hand, minimizing credit spread requires expertise and an understanding of pricing dynamics: 

  • Credit spreads are not known with certainty until pricing day, so underwriters cannot be selected based on proposed spreads. 
  • Final pricing is set by underwriters who do not have a fiduciary duty to borrowers. 

If an underwriter sets yields below market, there is significant chance that the bonds will need to be repriced, or worse yet, taken into inventory. However, if yields are set above market, the hospital is unlikely to find out unless it has the expertise to review pricing. 

To address pricing uncertainty in the underwriter-selection process, hospitals can analyze each firm’s past performance in comparable issues. This requires pricing expertise. To keep underwriters on their toes and exert some modicum of influence over the pricing process, the hospital should make it clear that pricing will be verified. Under the microscope, underwriters will sharpen their pencils and push for lower yields rather than risk losing future business. 

To be in position to influence the pricing process, the hospital must demonstrate to the underwriter that it does have the expertise to measure and compare credit spreads. This is where an experienced financial advisor looking over the underwriter’s shoulder can provide significant value, particularly if the underwriter knows the outcome may be shared with the financial advisor’s other clients.

Measuring Credit Spread

Once yields are set, borrowers are finally in position to measure credit spreads to verify pricing and determine if the bonds are being offered at competitive rates when compared to other issues. This can be a complex analysis since bonds involve different combinations of serials and term bonds, each sold at different premiums or discounts and different credit spreads. 

Faced with the need to perform time-consuming calculations, some industry participants use a shortcut and discuss credit spreads based on the long bond only (i.e., the longest maturity). This approach saves time, but often leads to erroneous conclusions because it ignores credit spreads for earlier maturities. 

A more accurate approach to pricing verification is to measure credit spread across all maturities. This can be done by applying the same concept used to calculate bond yield. The bond yield formula solves for the internal rate of return or discount factor that brings the present value of net proceeds and debt service cash flows to zero. 

Applying the bond yield formula to credit spreads, the total issue spread (or true spread) is calculated as the internal rate of return (or discount factor) that brings the present value of net proceeds and credit-spread cash flows to zero. 

In the example shown in the exhibit (below), two series of similarly-rated bonds issued on different dates are compared side by side using both methods. Both series are priced at identical spreads to MMD for like-maturities, so one would conclude that the two series priced similarly. A comparison based on the long-bond spread would also lead to the same conclusion. However, when compared based on true spread, series B achieved significantly better pricing than series A. 

Long-Bond Spread Versus True-Spread Approach

By measuring all maturities, the true spread approach provides a single measure of credit spread and eliminates the need to compare individual maturities. Using true spread, pricing verification can be performed by comparing bond issues with disparate maturities.

It should be noted that while credit spreads are relatively stable in the short run, they will vary over time, so comparing issues sold more than a few months apart is not advisable. A reliable comparison should always involve bond issues of the same rating sold at around the same time, preferably in the same state. If good comparables are not available, a knowledgeable financial advisor can make the adjustments required to keep the comparison on an apple-to-apple basis. 

Controlling the Process

In the capital markets, knowledge is power. When selling bonds to public investors, hospitals that demonstrate an understanding of credit spreads and how to accurately measure pricing can maintain control over the process and minimize the cost of debt. 


Pierre Bogacz is managing director, HFA Partners, Tampa, Fla. and a member of HFMA’s Florida Chapter. 

Chris Rea is managing director, HFA Partners. 

This article is adapted with permission from an article published on HFA Partners’ website.

Publication Date: Thursday, January 16, 2014