In a higher rate environment, it may make sense to assess whether healthcare organizations should alter their legacy fixed-pay swap positions and to define whether and how swap products might be used in future debt management activities.
Many healthcare organizations continue to have significant legacy fixed-pay interest rate swap portfolios. But a reassessment might make sense as the market moves toward higher rates.
Most existing swap positions are long-dated structures put in place before the credit crisis and largely remain due to the unacceptable termination costs. The Federal Reserve has initiated a modest tightening policy, which is reflected by increases in the federal funds target rate from 0.12 percent in October 2015 to 1.15 percent in October 2017. The Fed also announced in September that it intends to start unwinding in October the balance sheet it accumulated through the quantitative easing process. Both initiatives ultimately are expected to lead to higher interest rates and, therefore, improve valuations for fixed-pay swaps. Consequently, financial executives in health systems may want to begin to consider terminating swap positions if the marks were at or closer to zero.
Reasons Not to Terminate
Most fixed-pay interest rate swaps are performing largely as expected from a cash flow perspective. An organization with SIFMA-priced debt that is hedged by a 68 percent of one-month LIBOR swap has experienced periods of realized basis mismatch, but the average exposure since Jan. 1, 2004, has been only around 8 basis points. Pending tax reform may produce more sustained, structural basis mismatches, but net cash flow performance has not been the issue to date.
At inception, most legacy fixed-pay swaps were matched against insured auction rate securities, which since have been replaced with either letter-of-credit-backed variable rate demand bonds (VRDBs) or direct purchase loans from commercial banks. This transition has positively affected the “event risk” profile of these positions but has had a more varied impact on realized net cash flow.
Auction rate add-ons included the amortized cost of insurance plus auction agent fees; these have been replaced by letter-of-credit plus remarketing fees for VRDBs or a credit spread for direct purchase loans. The net cost increase is likely highest for lower-rated organizations that might have less access to favorably priced bank credit and liquidity support. But even with these adjustments, the net cash flow component has remained generally in line with expectations.
The other consideration in favor of retaining legacy swaps is that they continue to offer a long-term hedge against rising interest rates. As the Fed acts and benchmark rates move higher, swap valuations on these long-duration positions will narrow and may shift to positive in a higher-rate environment. Consequently, market forces that improve swap valuations may lead some executives to elect to leave these positions in place, especially because the alternatives available at that point (natural fixed or unhedged floating products) will likely result in higher total capital costs than would be incurred if the synthetic structure were left in place.
Reasons to Terminate
A core reason for terminating a position in a higher-rate environment is to remove all risk from the organization’s overall capital structure. A challenge to maintaining a fixed-pay swap portfolio is the need also to maintain an underlying portfolio of floating-rate debt. Most organizations originally built long-dated fixed-pay swap positions on an insured auction rate foundation, which seemed to offer committed capital and protection from collateral posting. After foundations crumbled during the credit crisis, organizations have been dealing with floating-rate products mostly accessed through banks. These products have more embedded event risk and collateral posting pressures than do auction rate securities. Eliminating the swap position would increase the flexibility to move to traditional fixed debt or other underlying debt structures that rely less on banks or have an improved risk profile.
Another subset of organizations likely will be interested in terminating swaps while retaining the underlying floating-rate debt portfolio. Included are those that want to revert to net floating exposure, perhaps because they have invested asset pools that already offer a hedge against rising rates or they expect to be adequately compensated in net cost through inclusion of floating-rate debt in their capital structure.
A third subset includes the wide array that have derivative “fatigue.” These health systems have kept legacy swap positions in place for an extended period and have limited interest in maintaining a swap position once it reaches an acceptable termination value. Although this sentiment is understandable, their thinking may adjust as rate regimes rise and the hedging part of a fixed-pay swap comes more into play.
Swaps Going Forward
For all senior finance executives—even those with derivative fatigue—it is important to consider the role that various swaps might play in a higher-rate capital structure. Thinking about whether legacy positions could be retained as rates move up might lead to a conclusion that value can be realized by restructurings that “reconnect” a swap portfolio with a floating-rate debt portfolio.
Also, new fixed-pay swaps can be structured to include early “zero value” termination options, which allow but do not require borrowers to terminate at zero value after a future date—much like a call provision on a bond. An important consideration is that, by changing the mark-to-market performance of the swap, this approach will impact any fair value hedging element. Such value might be realized in a sharply higher rate environment. Organizations have several different levers—from portfolio diversification to early termination mechanisms—to better manage the bigger swap-based risks.
If rates do rise, it is important to remember that new swap strategies that can help reduce costs eventually will come into effect. Fixed receive swaps, for which organizations pay floating rates and receive fixed rates, can be paired with fixed rate debt to create attractive net floating rate exposure. Executives will need to carefully assess how far to extend the duration of a fixed receive strategy to avoid the reverse event risk issues experienced with long duration fixed pay swaps, but they should expect higher rates to prompt the need for implementation of this strategy.
It is likely that interest rates are headed higher, but the pace and severity of this change is uncertain. Healthcare finance executives should develop a plan of what they might do in a higher-rate environment and use this plan to assess whether changes are needed in their legacy fixed-pay swap positions and to define whether and how swap products might be used in their future debt management activities.
Eric A. Jordahl is a managing director, Kaufman, Hall & Associates, LLC, and a member of HFMA’s First Illinois Chapter.