The Impact of Tax Reform on Hospital Capital Financing
Higher hospital tax-exempt rates may result.
The Tax Cuts and Jobs Act is the most comprehensive change to the U.S. tax code since 1986. For not-for-profit hospitals relying on debt for most of their capital structure, the act has two major implications: The change in corporate income tax rates may push up tax-exempt rates and make bank placements more expensive, and the prohibition against advance refundings may steer some hospitals toward complex alternative structures with new risks.
Change in Corporate Income Tax Rates
The tax reform act reduces the corporate income tax rate from 35 percent to 21 percent. While at first glance this would appear to affect only corporate earnings for taxable securities, some industry experts expect it will result in higher tax exempt rates for hospitals because taxable earnings will become more attractive for corporate investors relative to tax exempt earnings.
When corporate investors evaluate municipal bond returns, they often use the tax equivalent yield of tax exempt earnings, defined as the pretax yield that a taxable bond needs to offer to be equal to that of a tax exempt bond:
Tax Equivalent Yield = Tax Free Municipal Bond Yield (1 – Tax Rate)
If corporate income tax rates are reduced, so are the tax equivalent yields, which makes tax exempt yields less valuable relative to taxable yields. Lowering the corporate tax rate from 35 percent to 21 percent causes the corporate investor’s tax equivalent yield for a 4 percent tax exempt coupon to drop by more than 1 percent.
Facing lower tax equivalent yields, some corporate investors will ask for higher tax exempt yields. Others will reallocate assets away from tax exempt holdings and into taxable instruments, which impacts demand and could also result in higher tax exempt yields.
The impact of corporate tax reform will vary based on investors’ specific tax situations. It is expected to be less pronounced in public bond markets, where 59 percent of buyers are direct and “back-door retail” investors—unaffected by corporate tax reform—and another 14 percent are insurance companies paying a low average effective tax rate (ETR) of 15 percent : (Damodaran, A., Tax Rates by Sector , NYU Stern School of Business).
The situation is different in the private debt markets, where direct placements dominate and lenders pay higher corporate rates relative to other investors.
Direct placements are tax xempt bonds sold in limited offerings to single investors, generally commercial banks. Compared with public bond offerings, direct placements involve lower costs, more streamlined disclosures, and less time to closings. Hospitals have been behind growth in direct placements.
Banks pay an average tax rate of approximately 26 percent, so they are more likely to feel the impact of corporate tax reform on tax equivalent yields, which means hospitals may see bank placement rates go up. Lenders without other business to fall back on, such as treasury management or purchasing cards, may feel more pressure to bump up yields.
Existing bank placements can also be affected depending on their yield protection language, which allows banks to increase rates to make up for changes that affect profitability. Yield protection language can vary significantly from one placement to another, so not all placements will be affected.
If a bank invokes the clause and adjusts rates, this may also affect hedge accounting if hospitals use swaps to synthetically fix rates on floating rate debt.Hospitals with bank placements should review their loan documents to prepare to discuss them with their lenders.
Prohibition Against Advance Refundings
The new prohibition against advance refundings could impact future call provisions and also cause hospitals to use alternative structures with new risks not found in traditional advance refundings.
In traditional advance refundings, hospitals achieve savings by selling refunding bonds today and escrowing proceeds to pay debt service on old bonds until they are called on first call dates. At closing, the refunded bonds are defeased and come off hospitals’ balance sheets. Advance refundings are popular with municipal borrowers, as rates have sunk to near record lows and net present value savings could be captured in spite of long and costly escrow periods.
Starting in 1986, rules limited tax exempt advance refundings to one per issue. The tax reform act now prohibits tax exempt advance refundings entirely, although current refundings and taxable advance refundings are still permitted.
Some industry participants are expecting that the loss of advance refundings will cause borrowers to ask for changes in call provisions associated with future bond issues, such as the following:
Shorter call dates. Most bonds sold in public markets have 10-year optional redemption provisions, generally at par. Some borrowers may wish to shorten these first call dates to five years or less. Shorter call periods are less attractive to bondholders, so they typically carry higher yields or call premiums.
Make whole call. Make wholes permit early redemption, which can be helpful in mergers and other non-economic refunding situations, but at the cost of paying future scheduled principal and interest payments, eliminating savings.
Although tax exempt advance refundings are no longer permitted, the following alternate structures may achieve savings, but hold additional risks.
Taxable advance refunding bonds. Hospitals sell taxable bonds, and while the higher yields reduce savings, the savings are locked in today, and the assets previously funded by tax exempt debt are no longer restricted. On first call date, hospitals have the option to issue tax exempt bonds to current refund the taxable bonds, assuming favorable rates.
Taxable exchangeable “Cinderella” bonds. The hospital sells taxable bonds that convert to a pre-determined tax exempt rate on first call date, which locks in savings. The structure can involve complex tax issues for the hospital and may not be available for long call dates.
Forward delivery bonds. The hospital enters into a bond purchase agreement to sell tax exempt bonds to a bond underwriter on first call date as a current refunding at a pre-determined rate. This structure has call limitations and may be contingent on future investor demand.
Forward bond option. A hospital sells the option to issue current refunding bonds and receives an up-front payment. If on first call date the opetion is exercised, refunding bonds are sold and the investor receives excess proceeds or pays any shortfall needed to fully redeem the old bonds. If the investor does not exercise the option, the hospital retains the right to call the old bonds. This structure is not a swap, so it doesn’t require an ISDA master agreement, but it involves credit and market risk.
Rate lock. Hospitals enter into forward swaps today that start and settle on first call dates. If rates have gone up, hospitals receive payments that are applied to reduce refunding par. If rates have gone down, hospitals make payments funded by increasing the refunding par. Either way, refunding debt service is relatively the same. This structure requires an ISDA and is priced on Municipal Market Data (MMD) or London Interbank Offered Rate (LIBOR). MMD eliminates basis risk but is more expensive. LIBOR involves basis risk but is less costly.
Swaption. Hospitals sell options to investors to enter into swaps that start on the first call date. If investors exercise the options, hospitals issue variable-rate debt to refund the old bonds and use the pay-fixed swap payments to synthetically fix rates on the refunding bonds. This structure requires an ISDA.
Draw down bonds. The hospital sells tax exempt bonds and draws proceeds to current refund maturities as they come due on the old bonds. On first call date, the balance of the proceeds is drawn to call the remaining old bonds.
With the exception of taxable advance refundings, other structures involve additional risks, some complex and difficult to analyze, so hospitals are well advised to seek a thorough review from an independent third party.
Balancing Risk and Reward
The tax reform act is expected to raise not-for-profit hospitals fund costs, particularly those that rely on bank placements for large portions of their debt structures. With advance refundings prohibited, some hospitals will consider other risky refunding structures. Hospitals should review existing bank documents and, if considering bond refunds ahead of call dates, determine the risks.