Bond Ratings and Access to Capital in the Current Market Scott Winter PNC Capital Markets Healthcare Investment Banking email@example.com 216-222-9420
Rating Agency Perspective – 2011 Not-for-Profit Healthcare Outlook • Moody’s maintains a negative outlook for the U.S. not-for-profit healthcare industry, while S&P and Fitch expect the sector to remain stable in 2011. • Softer volumes and adverse changes in payer mix are the result of the economy’s slow recovery, continuing unemployment and reduction in healthcare utilization. • Negative pressures on hospital reimbursements will continue to stress operations. • Financial performance improved for many organizations in 2010; however, most of the improvement came from expenditure reductions rather than growth in top-line revenue. • Healthcare reform imposes additional uncertainty and challenges. • Favorable attributes of the sector include the strength of management teams leading their organizations through this challenging operating environment. • A rebound in the investment markets improved balance sheets and contributed to growth in net income. • Moody’s and S&P both noted the shift toward additional fixed rate debt – an effort to reduce exposure to the certain debt structure risks.
Rating Agency Perspective – Upgrades versus Downgrades • Both rating agencies reported that the pace of rating downgrades slowed during 2010 compared to 2009. S&P reported more upgrades than downgrades in 2010 – the first time this occurred since 2006. • Stand-alone hospitals accounted for 63% of Moody’s rating upgrades whereas stand-alone hospitals accounted for 77% of S&P’s rating upgrades.
Moody’s Top 10 Credit Factors Driving Rating Changes Source: “Moody’s Top 10 Credit Factors Driving Rating Changes for Not-For-Profit Hospitals,” November 2010
Rating Agency Perspective – Key Factors • The rating agencies have expressed concern about the sustainability of improved operations noted in 2010. • Balance sheet strength – specifically, liquidity has received much focus. • New ratios have been developed and measurements established to evaluate the accessibility of cash • Additional focus on the quality of assets in the investment portfolio • Debt Portfolio • Assessment of risk and relevant mitigants • Diversification of credit enhancement providers and facility expiration dates • Swap exposure, hedge effectiveness, collateral posting requirements, and termination events • Quality of the management team and governance • New Projects • Funding/Access to capital • ROI
Access to Capital – Sources of Capital • Balance Sheet Cash • Accessibility, diminishing reserves • Sale of Assets and Monetization of Real Estate • Cash Flow from Operations • Capital Campaign, Fundraising and Grants • Restrictions • Construction Loan/Temporary Financing • Fixed Rate Bond Issue • Full security package expected, covenants and continuing disclosure • Variable Rate Bond Issue • Bank LOC, SBPA or self-liquidity • Additional risk exposure • Bank Placement • Diminishes bank credit capacity for lines and/or credit facilities
Traditional Fixed Rate Bonds Most conservative structuring alternative Eliminates ongoing interest rate risk Bonds typically not callable for 10 years Can issue bonds with a maturity of up to 40 years Bonds issued based solely on the credit strength of the issuer or with bond insurance Security, covenants and disclosure may include all, or most of the following: Revenue pledge, mortgage, debt service reserve fund Tightened liquidity and capital structure covenants – additional ratios have emerged, including variable rate and short term debt ratios/measures Quarterly disclosure Credit rating from multiple agencies Capital Markets – Financing Alternatives
Fixed Rate Bond Pricing • The “MMD” curve is the municipal risk-free curve off of which all long-term municipal bonds are priced in the primary market. • It is an index derived from the trading activity of AAA-rated, tax-backed general obligation municipal bonds. • Municipal bonds is correlated to, and can be said to be derived, from the Treasury Curve. • But there are many of factors affecting the derivation of muni bond rates • First, you have all of the things affecting Treasury rates: the state of the US economy, monetary policy, world events, etc. • Then other things are factored in: • Federal tax law • Federal, State and Local income tax rates • Sector-specific credit risk (government, higher ed, healthcare, etc.) • Entity specific credit risk/credit rating, security structure • Supply and demand
Fixed Rate Bond Market Overview • The tax-exempt fixed rate bond market remains volatile. • Municipal bond issuance dropped to an 11-year low in January 2011. • Record withdrawals from the municipal bond funds have diminished demand for municipal bonds – it’s a buyer’s market. • Investors have come to expect significantly more than in the past – collateral, covenants, and disclosure. • As municipal yields have increased from the historic lows reached in 3Q10, many borrowers have pulled prospective fixed rate issues opting to wait until volatility subsides. • Refunding bond issues have been shelved. • New projects have been postponed or are being funded with temporary funds. • Plans of finance have been revised to include more bank debt and/or short term debt.
Healthcare Credit Spreads 30YR Rated Healthcare versus MMD General Obligation Index
Capital Markets – Financing Alternatives • Variable Rate Demand Obligation (VRDO) with Direct-Pay Letter of Credit (LOC) • Short-term multi-mode interest rate reset (weekly, daily, monthly, etc.) • Exposure to interest rate risk • Produces lower cost of debt when yield curve is normal (upward sloping) • Provides the most flexible redemption options • The bonds will be sold on the credit strength of the bank providing the LOC • LOC terms can be extended 3 to 5 years with annual renewal provisions • Interest rates at historically low levels • Successful remarketing each week • Bank letters of credit may be challenging to procure • Fewer options due to credit deterioration throughout the industry • Bank renewal concern • Pricing may be tiered to rating and/or financial performance • Ancillary business may be required
Variable Rate Bond Market Overview • The tax-exempt variable rate bond market is an attractive alternative for those borrowers that understand and can tolerate the associated risks. • Variable rate demand bonds continue to reset at historically low interest rates • Letter of credit pricing has been trending lower since mid-2009. • Much attention has been given to the volume of letters of credit and standby bond purchase agreements set to expire in 2011. • The implications of the Basel Accord on bank capital requirements and the resultant impact on credit capacity, are arguably not fully understood.
Variable Rate Bond Pricing • The SIFMA Index is a tax-exempt high-grade, seven-day variable rate demand bond index. • This is the index off of which seven-day reset variable rate demand bonds are priced. • This index has historically been highly correlated to short-term money rates, such as one-month LIBOR, and the Fed Funds rate, and adjusted for the tax benefit. • It is still highly correlated to the Fed Funds rate, however, since the short-term rate compression occurred in early 2009, the tax-benefit has had little to effect on the index. • Notwithstanding about four weeks in the fall of 2008, this is a highly functioning, very liquid market • We expect rates to remain stable until the Fed begins to raise the Fed Funds target rate. • The interest rates on variable rate demand bonds are largely insulated from the credit issues affecting the long-term fixed rate market, but since this market is mostly dependent on highly rated banks to provide credit and liquidity support it is heavily influenced by the state of the banking industry.
Capital Markets – Financing Alternatives • Synthetic Fixed Rate Bonds • An interest rate swap “synthetically” converts interest rate exposure from variable rate to fixed rate. • Typically results in lower fixed rate funding costs relative to traditional fixed rate alternatives. • Eliminates most interest rate risk; basis risk remains. • Other risks (depending on swap structure and underlying variable rate issue) include: counterparty risk, tax risk, credit risk, LOC renewal risk. • Counterparty may require posting of collateral beyond a market value threshold. • Swap contract will likely include automatic termination events tied to financial performance and/or bond rating. • Accounting treatment, specifically marking to market, may have a significant impact on the financial statements.
Other Financing Alternatives Taxable bank loans • Taxable rates are usually higher than tax-exempt rates. Capital leases • Shorter term; most are typically taxable. Tax-exempt private placements • ARRA had amended bank qualified rules; however, these provisions lapsed December 31, 2010. • Recently, banks have become more competitive in both pricing and terms. • Costs to execute are relatively low when compared to a capital markets solution. • Terms might not extend to full amortization, subjecting a borrower to refinancing risk at the time of mandatory tender/or balloon payment. Governmental programs • Typically used by smaller, rural hospitals with limited access to alternate credit.
Closing • The not-for-profit healthcare sector has historically been very capital intensive – and healthcare reform will likely increase this burden. • Capital requirements can not be funded through operations, fundraising and grants alone. • Although pockets of stability have occurred since the significant market dislocation of 2008, volatility and uncertainty remain. • Variable rate bonds have continued to remarket at very low, attractive rates – yet impose certain risks that were amplified following the 2008 crisis. • There is a direct correlation between credit quality and accessibility and cost of capital. • The strongest credits have much more flexibility in terms of credit access, cost, and terms and can be selective when choosing financial counterparties.
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