In some cases, refinancing bonds sold when rates were high can pay off.
At today’s low interest rates, refunding fixed rate bonds can generate significant savings depending on coupon and redemption provisions.
In the past 10 years alone, the 30-year tax-exempt benchmark yield shed 130 basis points (1.3 percent). Combined with the practice of “rolling down the yield curve” by refunding longer maturities with shorter, cheaper maturities, low rates can translate into sizable debt service savings.
AAA General Obligation Tax-Exempt Benchmark Yield
Refunding Guidelines
The first consideration in evaluating refunding structures is to determine whether the bonds are currently callable. If not, they may be eligible for an advance refunding, but, per IRS rules, they are only eligible if they haven’t been advance refunded before. Eligibility for an advance refunding can be confirmed by bond counsel.
Other considerations include the minimum savings that make the refunding worthwhile and the savings’ sensitivity to rates.
A common threshold for minimum savings is when net present value (NPV) savings reach 3 to 5 percent of the refunded debt. NPV savings are calculated based on the difference in cash flows between the refunded (old) and refunding (new) debt, present-valued at the refunding bond all-in yield. The sensitivity of savings to rates also can help determine when to refund. By knowing how much rates must rise by the first call date for a current refunding to produce lower savings than with an advance refunding, hospitals can decide on timing and structure.
Breakeven Analysis of Current vs. Advance Refunding
In the refunding example shown in the chart on page 5, if rates climb only 75 basis points over the next three years, savings from an advance refunding done today would exceed savings from a current refunding.
Refunding Structures
There are several structural options for locking in refunding savings in the municipal bond markets.
Current refunding. A current refunding is the simplest refunding structure. In a current refunding, the hospital sells refunding (new) bonds and calls the refunded (old) bonds within 90 days. A current refunding results in the old bonds being legally defeased—taken off the books—on the date of closing.
Advance refunding. In an advance refunding, the hospital sells new bonds today and deposits the proceeds into an escrow. The escrow is released on the first call date to redeem the old bonds. An advance refunding usually results in the old bonds being legally defeased on the date of closing. The challenge with advance refundings is that until the call date, the hospital is paying two debt service streams: one for the new bonds, the other for the old bonds (paid by the escrow). Accordingly, the escrow must be sized to cover old debt service. Although the escrow earns a return, in a low-interest rate environment, this return is less than the debt service it must cover. This is known as negative arbitrage, and given a sufficiently long escrow period, it can eliminate savings. For example, a five-year escrow structured today would earn less than 1.5 percent. If the underlying bonds pay 6 percent, the escrow must be sized for the 4.5 percent net interest expense during the escrow period. Bonds ineligible for a tax-exempt advance refunding can still be advance-refunded with taxable bonds, but higher taxable rates are usually detrimental to savings.
Crossover refunding. In situations where an advance refunding is not permitted under IRS rules, a tax-exempt alternative is a crossover refunding. A crossover refunding is similar to an advance refunding in that hospitals sell new bonds to fund escrows at closing, but unlike an advance refunding, hospitals continue to pay debt service on the old bonds until the first call date, at which time the escrow is released and the old bonds are redeemed. While a crossover refunding does not count as an advance refunding, and so gives hospitals access to a tax-exempt refunding, it does not usually result in a legal defeasance until the call, so both the old and the new debt are on hospitals’ books. However, depending on existing bond documents, hospitals may be allowed to exclude one of the two issues from various covenants, including additional debt tests, and rating agencies may adjust their ratios accordingly, which minimizes the impact of the additional debt on the hospital’s financial profile.
Forward delivery bonds. A less common structure, forward delivery bonds are priced on a given date but not issued and delivered until a future date, at which point the old bonds are called. Because the bonds are sold today at current rates, this structure effectively locks in savings. However, forward-delivery bonds are not generally available for periods longer than a year, and there may be some outs for bondholders on delivery date, which creates additional risk and limits their popularity.
Forward bond option. A forward bond option is conceptually similar to a forward delivery bond, but the counterparty (buyer) is sold the option—not the obligation—to buy the refunding bonds at a future date. In return for this option, the buyer makes an up-front payment to the hospital representing the present value savings of the refunding. If, on the call date, the rates are below the old coupons, the buyer exercises the option to buy the bonds at market rates, and the hospital keeps the up-front payment. If rates are higher than the old coupons, the buyer does not exercise the option and the hospital keeps the up-front payment and the option to current bond refund later.
Rate lock. This structure allows a hospital to lock in a tax-exempt benchmark yield —for example, the Municipal Market Data (MMD) for a given maturity. If on the bond pricing date, the benchmark yield has gone up, the hospital receives a payment that is applied to reduce the par amount of the refunding bonds. If the yield has declined, the hospital makes a payment, which is funded by increasing the par amount of the refunding bonds. Either way, the refunding debt service remains similar to what it would be today, plus the cost of the lock.
Forward-start, cash-settle swap. The mechanics of the forward-start, cash-settle swap are similar to a rate lock, but the swap is based on a percentage of the LIBOR (Intercontinental Exchange London Interbank Offered Rate) swap rate. This swap structure is more popular than an MMD rate lock because it is cheaper and the forward period can go out much longer. However, it introduces risk that taxable and tax-exempt rates may not move in unison (i.e., basis risk).
Risks
It’s important to note that options that defer issuance to a date in the future—rather than selling bonds today and locking in current rates— involve taking on credit and market risks. Credit risk is the risk that savings will be lower due to deterioration in hospitals’ credit quality between the date the hedge is put in place and the date hospitals access the bond markets, which could result in higher interest rates for the refunding bonds. Market risk is the risk that market conditions may change and that bondholders demand greater credit spreads or stricter terms independently of any changes in hospitals’ credit quality.
The Challenges of Choice
It can be challenging for hospitals to identify and evaluate refunding options, not only because of their complexity, but also because bond underwriters and banks may not offer every option, so terms must be solicited from different parties. This can be a chicken-or-egg proposition for hospitals that lack current knowledge of market participants or structures, locking them into specific structures before they have sufficient information to make choices.
For that reason, some hospitals hire an independent registered municipal advisor, or “IRMA.” The advisor helps underwriters comply with the SEC Municipal Advisor rule, which restricts communications between broker dealers and municipal obligors. More important, the advisor helps identify, solicit, and simultaneously evaluate structures based on hospitals’ specific situations and objectives. If these structures involve credit or market risks, the advisor analyzes these risks and reflects them in the plan of finance.
With complete and objective information, hospitals can select the refunding option to optimize savings on acceptable terms and with minimal risk.
Pierre Bogacz is managing director and co-founder, HFA Partners, LLC, Tampa, Fla., and a member of HFMA’s Florida Chapter.
