5 Observations on the State of Hospital Credit Markets

The credit and debt markets have been markedly different since 2008, when the United States and much of the world officially entered a financial crisis that impacted the credit of almost every borrower.

Hospitals and other healthcare borrowers are no strangers to the evolving credit markets. Everything from the Eurozone crisis to the Libor scandal to the continuing, sluggish economy in the United States has had a direct or indirect impact on hospitals, their investments and their ability to borrow.

Here are five observations on the current state of the hospital credit markets.

1. Interest rates are historically low, leading to a favorable market.
The federal funds effective rate has held around 0.16 percent in the past several months — a historically low interest rate for general borrowing, as the federal government continues to try to stimulate the economy.

For hospitals and health systems, the key rates within the tax-exempt market — the Municipal Market Data rate, the Securities Industry and Financial Markets Association municipal swap index and others — have also been exceptionally low, which makes borrowing much cheaper. On July 24, the 30-year MMD hit a record-low of 2.8 percent.

Steve Kennedy, senior vice president and investment banker for Lancaster Pollard, says there are a couple of indices that are very indicative of the current interest rate climate. For healthcare providers rated "A" or higher by credit rating agencies, interest rates have been most advantageous, and even hospitals rated "BBB" or higher — which are at the lower end of the "investment grade" spectrum — are able to secure capital at relatively favorable yields

For example, over the past year, 30-year "A"-rated healthcare yields are down more than 140 basis points from 5.75 percent in 2011 to 4.33 percent this year. Thirty-year "BBB"-rated healthcare yields have also experienced a similar decline, down from 6.53 percent last year to 5.17 percent over the same time period.

"The movement of both 30-year curves has enabled investment-grade healthcare credits to experience significantly lower fixed-rate borrowing costs," Mr. Kennedy says. "Additionally, what the curves do not necessarily communicate is that healthcare borrowers are now enjoying greater access to fixed-rate markets, particularly when compared to the municipal market just a couple years ago."

Non-profit hospitals have historically concentrated most of their long-term borrowings in the tax-exempt markets, where rates tend to be lower due to the tax advantages provided to investors of tax-exempt papers. However, hospital CFOs should also analyze current trends in the taxable, or corporate, bond market — a market significantly larger than the tax-exempt debt universe.

Pierre Bogacz, managing director and co-founder of HFA Partners, points out that when it comes to variable rate debt, the advantage has shrunk considerably. For example, the SIFMA seven-day rate (for tax-exempt bonds) is currently 0.16 percent while the one-month Libor rate (for taxable bonds) is 0.25 percent: On a $50 million borrowing, this represents annual savings of only $4,500, something Mr. Bogacz says is hardly worth the costs of getting a tax-exemption.

"The record-low rates have really removed the advantage of the tax exemption from the short end of the yield curve," he says. "But when rates go back up, the savings will come back, so it doesn't mean hospitals should abandon tax-exempt debt. Also, on the longer end of the yield curve, tax-exempt fixed-rate debt is still generally cheaper than borrowing on a taxable basis."

2. Credit spreads are still high. Mr. Bogacz notes that overall, for hospitals wanting to go to the debt markets, the climate is very favorable. However, while benchmark rates like MMD, SIFMA and Libor are at record lows, credit spreads for healthcare have remained relatively high. A credit spread is the difference between the yield on an "AAA"-rated general obligation bond and what a borrower rated less than "AAA" will pay. The lower the borrower's rating, the higher the credit spread. The high credit spreads for lower investment-grade hospitals have negated some of the savings that can be had from lower rates, he says.

"While credit spreads have come down in the last few months due to limited supply of hospital bonds, credit spreads are still very high compared to 10 years ago," Mr. Bogacz says. "That tells us that investors, particularly institutional investors who buy bonds in the primary and secondary markets, still think hospitals involve significant risk."

3. Larger, higher-rated hospitals and health systems tend to have more borrowing power, but smaller hospitals are still active. Generally, larger hospitals and health systems are more highly rated and enjoy better access to the debt markets. This is partially due to "strength in numbers," as large borrowers typically enjoy better margins and less variability in financial performance — which rating agencies and investors prefer.

"If you're a hospital rated 'AA,' and you're going to the market, you're looking at a spread of around 75 basis points," Mr. Bogacz says. "And you're also going to have access to additional structures and ways to tap into the debt market that a smaller hospital will not have access to."

Paul Storiale, former CFO of Robert Wood Johnson University Hospital in New Brunswick, N.J., says two years ago, the hospital completed a refinancing. RWJUH's strong credit rating — "A-" at the time from Standard & Poor's — made access to the debt market easier. He adds that since then, S&P has upgraded the hospital's rating from "A-" to "A."

However, Mr. Kennedy explains that smaller hospitals, which usually have lower credit ratings due to their generally more challenged credit profile, still have been active in the credit markets. Some successful smaller hospitals are carefully focusing on maintaining solid liquidity — high days cash on hand and a favorable cash-to-debt ratio — through effective balance sheet management in order to access the debt markets.

"The municipal investor market's appetite for healthcare paper has grown notably in 2012 as investors search for yield," Mr. Kennedy says. "This has enabled smaller hospitals, which tend to be lower-rated or nonrated, to tap into investors' growing demand for lower-rated credits, assuming the hospitals exhibit strong profitability, liquidity and capital structure ratios."

According to S&P's 2010 credit report, the following are median ratios for small hospitals rated "BBB":

•    Operating margin: 3.3 percent
•    Excess margin: 4 percent
•    Days cash on hand: 176
•    Cushion ratio: 12x
•    Cash-to-debt ratio: 115.2 percent
•    Historical debt service coverage ratio: 3.1x
•    Maximum annual debt service/revenues: 3.9x
•    Debt-to-capitalization ratio: 37.7 percent
•    Average age of plant: 7.8 years

4. Liquidity and an attractive business plan are both important to credit rating agencies. Whether a hospital is looking to refinance existing debt or issue "new money" debt, its credit rating — either publically rated or internally rated by investors — is critical to its cost of funds. S&P, Moody's Investors Service and Fitch Ratings issue credit ratings in the hospital and healthcare markets, and Mr. Bogacz says there are several areas hospital CFOs and executive teams can focus on to lower their borrowing cost.

Cash is always king, so hospitals should try to preserve and accumulate liquidity — this means cash and investments should be at above-median figures, even if this means taking on more debt to conserve cash. "Boosting liquidity is the quickest way to improve ratings," Mr. Bogacz says. "But of course that's easier said than done."

Mr. Storiale adds that when hospital executive teams meet with credit rating agencies, they need to explain every component of the hospital's business and why the hospital is in a good position to succeed. "Credit rating agencies look for a clear indication of where you're going," Mr. Storiale says. "In many cases, if the numbers may not be where they would like to see them but the plan is good, they'll listen."

5. Bank direct placements are on the rise. Bank direct placements are like publicly-sold bonds in that they are issued for new money or refunding purposes and can be tax-exempt. However, they are sold directly to a single bondholder, such as a bank, that holds the bonds to maturity. In the past three to four years, Mr. Bogacz has seen a huge increase in bank direct placements because they are seen as more cost-effective than public offerings. "In situations where they work, they can be a lot of cheaper," he says. "Since there is only one investor, there is no need to go through the expense of hiring a bond underwriter as you would with a traditional public offering."

According to Thomson Reuters, the trend is clear. In 2011, banks loaned roughly $2.9 billion in private healthcare lending compared with $503 million in 2010 — a difference of almost six times.

Mr. Kennedy cautions that while some investment-grade healthcare providers are leveraging direct placements to avoid some of the risks associated with letter-of-credit backed variable rate demand bonds, hospital leadership must keep in mind that bank-related debt is typically short-term in nature.

For example, while a direct placement may amortize over 25 years, the term is typically anywhere from three to 10 years. "If a hospital leadership team wants to eliminate the rate reset risk and refinance risk, true fixed-rate debt financing — whether via an unenhanced offering or an agency-enhanced offering like FHA mortgage insurance — should be considered," Mr. Kennedy says.

Hospitals can also combine debt structures, using bank-related short-term debt for the retail component of an offering and truly fixed-rate debt for the longer maturities. "It's important for hospitals to keep their exposure to bank-related debt below the system's total cash and short-term fixed income investments," Mr. Kennedy says. "Using the hospital's liquidity position as a natural hedge against interest rate and refinance risk is a nice starting point to determine how much bank-related debt exposure is prudent for a hospital."

Hospitals and health systems that are looking into bank direct placements should also be aware that like any financing instruments, all eggs should not be placed into one basket. "A bank direct placement is like a loan," Mr. Bogacz says. "Unlike with a letter of credit, you don't have put risk, but you may still have renewal risk, so it's important to make sure your lenders will be around. We recommend hospitals build relationships with more than one bank."

More Articles on Hospital Finance:

Should Hospitals Start Disclosing Bank Loans on EMMA?

Lower-Rated Hospitals Face Bond Challenges in 2012

Financial Fitness: A Well-Rounded Credit Profile Improves Access to Capital

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