Healthcare finance executives should be assessing variable-rate options for future financings and for the optimal diversification of variable-rate products in their organizations’ current portfolios, given fixed-rate debt and the liquidity of investment holdings.
With the Federal Reserve’s benchmark interest rate held to near zero for seven years, fixed-rate debt continued to dominate healthcare borrowing in 2016. Historic low rates induced many hospitals and health systems to issue fixed-rate bonds to finance capital needs, refinance outstanding fixed-rate bonds for savings, and in some cases, refinance variable-rate debt.
Fixed-Rate Issues Versus Floating-Rate Issues, 2007-16 ($ in Billions)
The exhibit above shows the proportion and amount of fixed- and variable-rate debt issued from 2007 to 2016. In 2016, a higher-than-ever 88 percent of debt ($38.8 billion) was fixed; 12 percent ($5.4 billion) was variable. Overall, during the past decade, 69 percent of nearly $360 billion of issued debt was fixed rate and 31 percent was variable rate.
In December, the Fed raised its benchmark rate a quarter of a percentage, and signaled that additional gradual adjustments of the rate upward can be expected during the year as the economy improves. Whether interest rates are increasing or decreasing, however, history continues to support the expectation that variable-rate instruments will cost less over time than fixed-rate alternatives. The exhibit below shows that over a 15-year period, the variable-rate index for tax-exempt debt (Securities Industry and Financial Markets Association [SIFMA]) was lower than the benchmark fixed-rate index for tax-exempt debt (Municipal Market Data [MMD]) in most years—and at many points considerably lower. This has especially been true in the years following the credit crisis.
Tax-Exempt Fixed-Rate (20-Year MMD) Versus Tax-Exempt Floating-Rate (SIFMA)
Variable-rate debt is a proven cost-saving strategy for healthcare borrowers—when its risks are appropriately assessed and managed within the organization’s capital structure, credit, and overall risk profiles. Because variable-rate interest cost savings remain substantial in the current market, a larger proportion of variable-rate debt financing might be expected in 2017.
Healthcare borrowers should be contemplating how much variable-rate debt and what types of such debt their organizations should be carrying.
Numerous factors play a significant role in determining an appropriate variable-rate exposure target for an organization and suitable products for that target. Analyses should include factors such as an organization’s credit profile, size, investment liquidity, performance trend, existing capital portfolio, and overall risk tolerance enterprisewide. Organizations with multibillion dollar revenues and higher credit ratings may be able to carry the perceived risk of a larger proportion of variable-rate debt in their debt portfolio than can other organizations with lower revenues and ratings. Changing tax rates, regulation, and capital lending requirements with the new administration could affect the level and type of risk of particular products. A strong understanding of the shifting risk dynamics with each product and their combinations, a thorough risk assessment, and development of risk-mitigation strategies are recommended.
Risks Versus Rewards
Like fixed-rate options, variable-rate debt is accessed through public or private instruments, with much of the recent healthcare activity occurring in the direct-purchase bank setting. Interest rates reset on a periodic basis to a predetermined formula or defined index, most often adding a borrower-credit-related spread off a percentage of LIBOR (London Interbank Offered Rate) as a proxy for SIFMA.
For many organizations, a convenient, cost-efficient way to use variable-rate debt is with new-money projects with longer established drawdown schedules. Using variable-rate debt allows borrowers to incur a lower cost loan, and pay “as they go,” rather than having the negative carry of a long-term fixed-rate borrowing at 4 percent, for example. Combining variable-rate debt with fixed-payer swaps is a way to hedge interest-rate risk when using certain variable-rate products.
A high-quality, diversified variable-rate debt program avoids excessive exposure to any one form of risk, such as those listed in the sidebar above. Interest-rate risk is a key consideration. Healthcare borrowers should be conservative in how they think about potential variable-rate savings versus fixed-rate debt, because the savings can vary widely. Borrowers should base rate assumptions on longer-term averages of indices.
Choosing the correct mix of different variable-rate products is a high-priority task for healthcare finance leaders. A diversified program could include variable-rate demand bonds (VRDBs) backed by a bank facilities or self-liquidity, publicly issued variable index-based securities, bank or other lender loans (e.g., “direct purchase bonds”), and public variable-rate notes. In the strongest credit cases, a diversified program also could include unenhanced Windows VRDBs.
Each product will have different characteristics that should be considered. For example, with bank variable-rate direct purchases, considerations include operating and business covenants, reporting requirements, frequency of ongoing repayment provisions, yield maintenance and claw-back provisions, grace periods versus hard default, ratings-based pricing for credit spreads, term sheet/commitment expirations, and closing requirements.
Increased use of alternative variable-rate products can be expected as changes occur to interest and tax rates, capital markets dynamics, and healthcare regulatory and payment policies. These factors can compel a rebalancing within and between fixed-rate and variable-rate portfolios.
To fully assess tradeoffs in seeking the lowest cost of capital at an acceptable level of risk, healthcare finance executives should continue to focus on risk and risk relationships in their capital structure decision making. But finance leaders also must think about capital structure within the context of broader enterprise risk, which includes assets and liabilities, as well as operations. Consideration of any of these in isolation could negatively affect an organization’s overall risk.
Use of variable-rate debt and diversification of the variable-rate debt portfolio can help lower overall cost of capital for healthcare organizations. In measured amounts, variable-rate debt issuance can be a winning strategy even when rates remain below long-term averages. Risk assessment and ongoing mitigation strategies are key to successful management of variable-rate programs.
Eric A. Jordahl is a managing director, Kaufman, Hall & Associates, LLC, and a member of HFMA’s First Illinois Chapter.
Marcelo Olarte is a vice president, Kaufman, Hall & Associates, LLC.
Glenn N. Wagner is a senior vice president, Kaufman, Hall & Associates, LLC and a member of HFMA’s North Carolina Chapter.