With the Tax Cuts and Jobs Act of 2017, advance refunding of municipal bonds has almost been eliminated. Bonds can now be refunded within 90 days of their call date and still be considered a current refunding, which means the high volume of advance refunding, such as occurred between 2008 and 2017, will be a thing of the past or at least as long as the present law remains in effect.
Without question, the elimination of advance refunding had a major impact on 2017 volumes as hospitals rushed to the market in advance of the tax law change. The law also clearly had an immediate effect in 2018: Total municipal bond volume dropped almost 22% as a result of the tax law change while healthcare volume dropped from $34.7 billion to $22.8 billion, a decline of 34% (Source: Refinitiv, Jul 11, 2019). Year-to-date results in 2019 regarding the use of advance refunding suggest that the 2018 results, especially when considering refinancings both alone and in combination with new money, may be the new norm.
Looking forward, the period 1998-2008 may provide insight as to what to expect with the future volume of refinancings. The developments during this decade were attributable to a provision of the 1986 Tax Act that also affected the practice of advance refunding. Before the passage of the 1986 Tax Act, municipal borrowers could advance refund tax-exempt issues twice. After 1986, municipal borrowers were limited to one advance refunding.
Given the high-interest-rate environment of the 1980s, a high volume of refunding occurred in the late 1980s and 1990s when rates returned to more acceptable levels. Because these bonds, many of which were insured, were not eligible for a second advance refunding, the level of advance refunding as a percentage of the total market was lower than in the 2009-2018 period. In other words, the lower volume of refunding in the 1998-2008 might provide some insight on the impact of the change in refunding options.
The key point to consider is that rates remained relatively stable in the 1990s and early 2000s, so there was a reduced incentive to refund. Likewise, the low-interest-rate environment of the past ten years will have a similar effect on the need to refund, thereby neutralizing some of the immediate impact of the loss of advance refunding.
Variable-rate debt. An emergence from today’s lower-interest-rate environment to a higher one would almost certainly spark a renewed interest in variable-rate debt. Between 1998 and 2008, variable-rate debt represented, on average, about 20% to 30% of total debt, with the total reaching a high of over 60% in 2008. By comparison, variable-rate debt has constituted about 20% of the total since 2008. Part of the problem with our current data is capturing the information from the banks, which are major providers of variable-rate lending via direct purchases. Banks will be less inclined to write letters of credit or standby bond purchase agreements, which are somewhat constrained by Basel III limitations, and instead will continue to be a major source of variable-rate funding via direct lending.
A higher-interest-rate environment also will make hybrid variable-rate products more attractive. For example, tender option bond programs are likely to appeal to borrowers seeking a nonbank variable-rate solution. Hospitals also can expect more nonbank variable-rate products such as self-liquidity, floating-rate notes of various kinds and other hybrid securities.
A decade-long period of low interest rates may be coming to an end. As rates move higher, hospitals likely will revert to some familiar forms of financing and lenders will be poised to offer new products to meet the demand. It is reasonable to assume that conventional fixed-rate financing will remain the prime source of funding for hospitals. But it also is reasonable to expect that many borrowers will rely on variable-rate debt to a much greater extent than in the prior decade, if for no other reason than that they already have locked in fixed rates at reasonable levels and, thus, can afford to take on variable-rate risk.
How that variable-rate debt will be structured remains to be seen. Highly rated hospitals will be able to use their own credit to support variable-rate initiatives. Others will continue to rely on bank placements for their variable-rate needs.
It is not clear whether banks will revisit the use of letters of credit and standby bond purchase agreements. As long as reserve limitations imposed by Basel III continue to make credit facilities costlier to offer, bank lending will continue to be a major source of variable-rate financing for hospitals. If that proves true, the use of derivatives could be limited. Moreover, derivatives are likely to be scrutinized to a much greater extent than they were during 1998-2018 period, and they are likely to have shorter terms.
With no prospect of a new generation of bond insurers, hospitals will continue to rely on their own credit or those of the banks supporting them. Without external credit support, it is reasonable to assume that the hospital consolidation that has occurred over the past 10 years will continue as smaller facilities find it difficult to absorb the debt burden necessary to keep pace with evolving operational requirements.
With the elimination of advance refunding of tax-exempt bonds, it is also reasonable to assume that the volume of healthcare bond financing will diminish at least for much of the next decade. Consider 2018 as a harbinger of things to come in the public arena when it comes to future issuance of tax-exempt debt. Volume dropped from $34.7 billion in 2017 to $22.82 billion in 2018 (Source: Refinitiv, Jul 11, 2019). Of course, 2017 could be considered an aberration because of the rush to refund before the tax law change took effect.
On the plus side, larger hospitals and systems will rely to a greater extent on the taxable market as mixed-use (taxable and tax-exempt) projects become more commonplace. That practice may offset some of the lost volume from refunding projects.