Bond financing in volatile times: with balance-sheet pressures, volatile markets, and increased capital needs, capital access requires new sophistication

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Date: Mar. 2014
From: Healthcare Financial Management(Vol. 68, Issue 3)
Publisher: Healthcare Financial Management Association
Document Type: Article
Length: 2,353 words
Lexile Measure: 1540L

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In an era of healthcare reform, with declining payment, concerns about reducing costs, and exploration of new organizational structures to improve accountability for population health, uncertainty abounds among healthcare providers. Meanwhile, hospitals and health systems are expected to provide the latest clinical procedures and technology, in state-of-the-art facilities, to attract and retain physicians and to serve increasingly diverse communities.

To effectively meet these challenges, these organizations need to make ongoing investments in facilities, IT, and medical technology. Considerable investment and reinvestment are critical to the profitability and survival of hospitals and health systems today. Yet making that investment can be challenging in the ever-changing capital markets. Because the structure of capital debt can contribute to a hospital's overall risk, organizations should take care to select the appropriate debt structure when financing capital projects or refinancing existing debts.

Changes in the Capital Markets

Late in 3013, healthcare borrowers had access to low-cost capital through the municipal bond markets. The Municipal Markets Data curve hit a 40-year low as increased investor demand drove down healthcare bond yields, resulting in compressed borrowing spreads across the credit spectrum. The relatively low supply of healthcare bonds resulted in greater competition, also supporting that dynamic. Not-for-profit hospitals and health systems were able to take advantage of the resulting low rates to fund strategic projects or restructure outstanding indebtedness to realize significant debt service savings.

But that was then and this is now. After nearly five years of historic lows, interest rates rose sharply in 2013. Today's capital markets are a far cry from the more predictable healthcare finance markets of 2005 and 2006. Since the beginning of 2008, healthcare providers have witnessed historic market changes, from the collapse of auction-rate bonds and the collective downgrade of bond insurers to the restructuring of Wall Street and historically high spikes in tax-exempt rates.

Although fixed healthcare rates have remained volatile since 2007, tax-exempt variable rates have been consistently at historic lows, trading at or under 20 basis points (0.20 percent) for most of 2013. Tax-exempt bonds for not-for-profit hospitals are still a favored option for capital, but the structuring of that debt requires a strategic approach. Hospitals can issue bonds to the public based on their credit profile, selling bonds to retail and institutional investors, or they can offer bonds on a private placement or direct placement basis to one or multiple banks.

Access to capital is ultimately determined by a combination of microeconomic factors (the hospital's credit profile) and macroeconomic factors (the state of the capital markets). Today's funding possibilities are markedly different from those of the not-so-distant past.

Bonds: A Traditional Capital Source

Long-term debt--usually tax-exempt bonds, but in some cases taxable notes--is a popular choice for healthcare providers to access capital. Bonds and notes represent an obligation of the borrower to pay interest to the investor in return for the lending of capital over a given period of time. The interest rate paid to bondholders is determined by conditions in the capital markets and is influenced by several factors including the credit characteristics of the borrower, security provisions provided to bondholders, and the bond structure itself.

Although bonds remain the primary long-term debt source for many hospitals, the challenges that many hospitals are facing to maintain revenue and control costs may result in diminished credit characteristics, which in turn may result in higher interest rates or the need for credit enhancement. In short, accessing bonds requires more creativity and planning than ever.

Bonds can be rated or unrated. The ratings are determined by the rating agencies (Standard & Poor's, Fitch Ratings, and Moody's Investors Service), which charge a fee to assign a rating to a bond offering. The ratings themselves range from AAA to C and can change based on the hospital's or credit enhancement's financial profile. Ratings suggest to investors the amount of risk involved in purchasing a particular bond. AAA to BBB- bonds are considered "investment-grade." Unrated or low-rated bonds are often referred to as "speculative grade," "junk," or "highyield" bonds. The higher the bond rating, the stronger the hospital's perceived ability to repay the principal and interest associated with the bond and the lower the interest rate the hospital must pay to offset investor risk. Rated and unrated bonds generally can be sold or structured with or without credit enhancement. Unenhanced bonds are marketed solely on the strength of the borrower, while credit-enhanced bonds use enhancement vehicles such as mortgage insurance, letters of credit (LOCs), and bond insurance.

Credit enhancement shifts risk from the borrower to the enhancement provider, which traditionally makes bonds less risky and the debt more affordable to underlying borrowers. Enhancement does not change the hospital's credit rating; rather, it changes the rating on the debt, allowing the hospital to borrow at potentially lower interest rates. Credit enhancement can be provided by either commercial institutions, such as banks and bond insurers, or a public entity, such as a federal government agency.

Other forms of credit enhancement, such as LOCs, have become more expensive and more difficult to obtain or renew since 2008 as a result of bank downgrades, new and pending capital requirements such as the Basel III Accord, and negative perceptions of the healthcare sector. Bond insurance was a frequently used form of credit enhancement before the financial collapse of 2008, but bond insurers have largely disappeared today. There are no AAA-bond insurers, and there is only one active insurer in the healthcare sector. The federal government also created several credit enhancement programs to ensure that hospitals can access capital. Government agency enhancements put the credit support of the federal government behind hospital loans and bonds, making them more attractive (less risky) to potential investors. Credit enhancement makes sense when the savings it provides exceeds its cost.

Unenhanced Bonds

Investor acceptance of unenhanced bonds (rated or unrated) fluctuates based on credit market conditions. Unenhanced debt offerings are supported solely by the borrower's credit characteristics. Therefore, the financial pressures many hospitals are experiencing increase the challenge of accessing this form of capital. Bondholders are typically provided collateral in the form of a first mortgage and lien on property assets or a pledge of the organization's revenues and trustee-held reserves, including a debt service reserve fund. Government-owned hospitals may offer collateral in the form of a general obligation or specific tax revenue pledge.

Unenhanced bonds are typically structured as fixed-rate, with various intermediate maturities and a final amortization of 25 to 35 years from the date of issuance. The financing normally includes prepayment penalties in the first 10 years, known as the call feature, or prepayment period. These penalties can be structured in a number of ways, from a period in which no prepayment can occur to scaled penalties for prepayment--the prepayment flexibility (or lack thereof) will affect the interest rate of the bonds or notes. Most tax-exempt hospital bonds include a feature called a sinking fund that collects principal payments to be redeemed each year, similar to a traditional home mortgage, to avoid a large balloon payment or the need to refinance at maturity, a common feature in the taxable corporate bond market.

There is no prepayment penalty associated with normal sinking fund payments.

Because bond investors rely on the credit strength of the borrowing entity to assess repayment ability, the finance team should perform considerable due diligence and ensure that the bond-offering documents provide extensive disclosure to investors. The due diligence may include a market and financial feasibility study conducted by a recognized accounting firm experienced in assessing similar projects, examination by a rating agency, and full disclosure of the hospital's operations and historical financial results. There also is a requirement for ongoing disclosures of information to rating agencies and investors through a Nationally Recognized Municipal Securities Information Repository, such as Bloomberg LP or the Municipal Securities Rulemaking Board.

Hospitals or health systems that issue bonds and notes on their own merit do not have to pay fees to use credit enhancement; however, they may find capital more expensive over time and be subject to higher or longer prepayment penalties, potentially more restrictive covenants, and other investor requirements. This option may be more or less appealing to hospitals depending on the bond offering's size, its prospective rating, and interest rate levels at the time of the transaction. The suitability of unenhanced bonds depends on credit spreads, yield curves, and investor appetite. The hospital's finance executive should be able to articulate the circumstances under which this option should be considered.

BANs and Bank Financing

Bond anticipation notes (BANs) are short-term bonds (generally less than two years) in which investors are paid off with the proceeds of a bond issuance. The primary benefit of a BAN is its ability to provide capital that allows project work to begin without the delay usually associated with issuing tax-exempt bonds. The willingness of a financial institution or investors to purchase BANs depends on the hospital's credit profile and the relative certainty of the BAN takeout financing. Rating agencies scrutinize both of these credit attributes when rating BANs. As with unenhanced bonds, the current challenges hospitals are experiencing in maintaining revenue strength, controlling expenses, and investing for the future may create challenges in maintaining the credit position necessary for access to BANs.

BANs carry some risk; for instance, if a hospital's market or operations change significantly from the assumptions made at the time it issued a BAN, the hospital might find it costly to issue longer-term bonds to refinance the BAN. The hospital may prefer to wait for a more opportune time to issue debt, but the maturity of the BAN could force a hospital to borrow in longer-term markets or face significant penalties from the lending institution in the form of higher rates on a short-term loan, prohibitive financial covenants, and other operational restrictions.

Commercial banks can provide a hospital or health system with a short-term construction or "mini-perm" loan to begin work on a project in anticipation of a longer-term tax-exempt bond financing. Banks also can be a source for real estate or equipment term loans. Interest rates associated with these loans can be fixed or variable. Long amortizations, similar to traditional bonds, can be obtained, but a lender is usually only willing to commit to provide the funding for a limited period (five to 10 years), creating the need to refinance or pay down outstanding principal at maturity. Furthermore, many lenders are unwilling to commit to fixing the rate of the loan for its entire period, although a synthetic fixed rate can usually be obtained via an interest rate swap.

Tax-exempt bonds also can be privately placed with financial institutions, such as local banks or large bond funds. Smaller banks may not be able to purchase the entire bond amount, but the investment banker may be able to identify multiple banks to each buy a portion of larger debt issuances. This structure may allow the hospital to reduce issuance costs and potential time to market, but it is usually not viable for larger issues that exceed bank capacity. Privately placed bonds are singularly negotiated with one or a select group of investors, so depending on market conditions, disclosure requirements can sometimes be minimized and covenants made more flexible.

When tax-exempt bonds are "bank qualified," banks can deduct 80 percent of their purchase and carrying costs and can pass along the savings to borrowers by way of a reduced interest rate. The bonds must be issued for qualified tax-exempt obligations. Currently, only $10 million in bonds can be designated bank qualified by any single bond issuer (often the local municipality) in one year. Hospitals may be able to phase projects over multiple years if a project is over $10 million or if a portion of the issuer's bank-qualified limit has already been committed. If the local municipality has already met its limit for the year, hospitals in some states can seek out other qualified issuers with remaining bank-qualified bond capacity--for example, certain state or county agencies or authorities with the ability to serve as an issuer.

Mitigating Debt Risks

Because the structure of capital debt can contribute to a hospital's overall risk, hospital leaders should identify and mitigate risks associated with their hospital's debt, investments, and balance sheet. Although these factors are interconnected with total financial risk and should be considered as part of an organization's total debt management policy, a hospital can manage its risk exposure by choosing the appropriate debt structure to finance capital projects or refinance existing debt. Key considerations include fixed versus variable rates, ongoing financial covenants, collateral requirements, prepayment flexibility, and refinancing risk.

A hospital's financing team also should consider the nature and objectives of the capital project (e.g., renovation, replacement, acquisition) and objectives when evaluating structured debt products. The best option will be the one that fits the hospital's needs while achieving the lowest possible cost of capital within acceptable risk parameters.

For healthcare provider organizations, today's environment brings significant capital challenges: higher cost of capital, ongoing need for capital investment, and pressure on both revenues and cost. To meet these challenges, healthcare organizations must be more disciplined than ever as they set their strategic and capital priorities, assess their capital needs, allocate their capital spending, manage their credit profile, and choose their capital sources.


A competitive landscape for providers and changing market conditions require an understanding of key capital sources:

* Tax-exempt bonds remain an attractive capital source.

* Credit enhancement for bonds is more expensive and more difficult to find than it was in years past.

* Direct bond purchases by commercial banks mitigate the traditional risks.


For a comprehensive look at available financing options for large and small hospitals, including government-backed lending programs, such as the Federal Housing Administration Section 242 mortgage insurance program and the U.S. Department of Agriculture's loan programs, read "Focus on Health Care Finance,"

Kenneth A. Gould is senior vice president, Lancaster Pollard, Philadelphia, and a member of HFMA's Metropolitan Philadelphia Chapter (

Christopher M. Blanda is vice president, Lancaster Pollard, Columbus, Ohio, and is a member of the Indiana and Kentucky HFMA chapters (

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Gale Document Number: GALE|A364691474