The Silver Lining for Non-Profit Hospitals: Utilizing Bond Derivative Swaps to Control Costs and Generate Revenue

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A common theme for non-profit hospitals is that short-term reimbursement measures are credit positive, while long-term initiatives pose credit negative factors. The Aug. 1 announcement from the CMS that hospital inpatient reimbursement rates will increase 2.8 percent for fiscal year 2013, is a positive short-term opportunity because the projected increase was estimated at 0.9 percent.[1] By way of contrast, the Patient Protection and Affordable Care Act, which the Supreme Court upheld in June 2012, was seen as mandating a slowdown in Medicare funding, while simultaneously providing for the individual mandate requiring individuals to purchase health insurance. This, coupled with the November elections, states opting out of the Medicaid expansion and reimbursement collaboration trends (i.e., hospital and insurer collaboration and physician employment) led to a long-term negative outlook for the industry.[2]

Yet, there is still a silver lining and a way for non-profit hospitals and health systems to capitalize financially. Utilizing various derivative options, hospitals can take advantage of interest rates and reduce the amount of capital it has to post on taxable financings (bond issuances). This article provides: (1) an overview of the municipal bond landscape and (2) security derivative options, which may enable hospitals and health systems to better position themselves in the short-term and mitigate the impact of the projected long-term sector reimbursement reductions.

Healthcare bond landscape

Of the $3.7 trillion municipal bond market, hospital bonds make up 7 percent.[3] In the 2012 bond market landscape, non-profit hospital debt earned nearly 4.9 percent more than the municipal bond market.[4] This is because hospital debt typically carries lower credit ratings (scales used by agencies such as Moody's or Standard & Poor's (S&P) that express an opinion about an issuer's credit risk) and higher yields.

In 2011, S&P indicated that, "our view of the relatively high level of reimbursement and regulatory risk in the health care sector is a component of what we see as the sector’s industry risk."[5] Despite the perception that hospitals and health systems judiciously contained costs while grappling with obstacles such as bad debt, low patient volume growth and lower reimbursement, only five AA+ ratings (no AAA ratings) were assessed to the 560 non-profit acute care issues. Additionally, future reimbursement adequacy from public funds and, subsequently, the possibility of hospital rating downgrades in light of the 2014 PPACA reform provisions were on the horizon.

The overall conclusion was Darwinian in nature. Meaning that those hospitals with strong credit, balance sheets and business positions were in a better position to stave off reimbursement fluctuations and survive. While hospitals with slim operating margins and rigid cost structures are more likely to experience credit stress. Still, overall financial performance of hospitals and health systems remained stable.

Despite the many positive aspects of PPACA and the ability of hospitals to capitalize on various provisions such as bundled payments, value-based purchasing and accountable care organizations, an Aug. 15 report by S&P indicates that 2012 may end up differently due to reduced opportunities for cost-saving measures.[6] "Improvements of the past several years, such as robust cost containment, increased economies of scale and revenue enhancements, may be reaching their limit and thus will not be able to keep pace with longer-term revenue pressures, especially in light of weaker volumes," said the report.

However, these factors were not deterrents for the nearly 209 healthcare bond deals totaling $14.6 billion that were issued from January 2012 to June 2012. This trend reflects sustained confidence in the non-profit hospital sector when compared to the $9.8 billion transacted through 145 deals in 2011. Hence, opportunities exist for hospitals to reduce financing costs associated with bond payments.

Security derivative opportunities

Of the $14.6 billion in healthcare bond deals, approximately $9.4 billion have been through refundings whereby older debt is replaced with new debt at lower interest rates. Related opportunities exist in the realm of bond issuances and engagement in various types of derivative transactions known as "swaps."

Pre-2008, fixed-rate payer swaps (essentially, paying a fixed-rate and receiving a variable rate) were the norm for healthcare providers. Post-2008, as interest rates decreased, fixed-payer swap mark-to-market value dropped. The result: hospitals and health systems having to post collateral at unaccounted for levels. Herein lies an opportunity.

With the increase in refundings, hospitals should consider the following options that may mitigate the amount of collateral required to be posted on a debt swap. Whatever option is considered, relevant tax and security laws and regulations, especially if a counterparty is located internationally, need to be considered.

Options to consider that may mitigate the amount of collateral to be posted on a debt swap include:

  • Refund outstanding synthetic fixed-rate debt with traditional fixed-rate debt, and terminate the related fixed-payer swaps. This is most appropriate where integration has occurred. That is, the swap was integrated with the bonds for tax purposes. Therefore, the cost of terminating the swap can be financed with new bonds. This is akin to using a home equity loan to pay off a credit card balance.
  • Recoupon swaps. By buying down the fixed-payer rate on a swap, the negative mark and associated collateral requirements are reduced. This is a good option because the execution cost is low due to the present value of the lower rate equaling the cost of the recouponing.
  • Novate a portion of the swap portfolio. By terminating an existing swap with one counterparty and entering into a new, similar swap with another counterparty, there may be opportunities to reduce the collateral threshold. The collateral threshold is often offered by a swap counterparty and enables a hospital refrain from posting collateral until the swap value drops below the threshold amount. This could have a significant impact on a hospital's balance sheet because posting of collateral is required only when the threshold is exceeded by a negative swap value. (Note: Dodd-Frank comes in with mark-to-market provisions-liability area).
    • Example 1: Hospital has a collateral threshold of $20 million with one swap counter party. If the value of the swap decreases by $20 million, then no collateral is posted. But, if the swap value decreases (goes negative) by $25 million, then $5 million is posted.
    • Example 2: Hospital novates a portion of its swap portfolio with more than one counterparty. If two counterparties are involved, there could be collateral thresholds of $20 million for each counterparty. In this instance, once the novation has been executed, no collateral is required to be posted until the value of the swaps at each counterparty have reached the $20 million threshold, meaning that the value has to decrease (go negative) by $20 million for a total threshold of $40 million for the two counter parties.

Hence, there are ample opportunities for hospitals and health systems to capitalize on various derivative and rate transactions in order to favorably reposition themselves financially in preparation for the implementation of various initiatives under PPACA.

When looking at ways to offset decreased reimbursement, entities often employ (1) generating more revenue through increased numbers of paying patients, and/or (2) reducing operating and supply costs. In order to ride the uncertainties looming for the long-term hospital and health system sector outlook, considering security derivative options as another avenue to offset decreased reimbursement pay prove fruitful. By taking advantage of lower collateral postings and variable-rate basis in the short term, hospitals can save money and be better prepared for the upcoming reimbursement decreases and the implementation of various health reform initiatives.

Rachel V. Rose, JD, MBA is a principal with Rachel V. Rose – Attorney at Law, PLLC in Houston, Texas. She can be reached at

[1] Mark Pascaris, Medicare Rate Increases are Positive for Not-for-Profit Hospitals, Moody’s Weekly Credit Outlook, p. 4 (Aug. 9, 2012).
[2] Moody’s Investors Service, Moody’s Mid-Year Outlook for Not-for-Profit Healthcare Highlights Developing Risks (Aug. 16, 2012) (indicating that the reimbursement collaboration trends “entail significant execution risk and may require upfront capital.”).
[3] Mike Cherney and Kelly Nolan, UPDATE: Hospital-Related Muni Bonds Calm After High Court Ruling (June 28, 2012), available at
[4] Michelle Kaske, Best-Returning Hospital Municipal Bonds Get Fuel From Court: Muni Credit, Bloomberg (June 29, 2012), available at
[5] S&P: U.S. Downgrade Has No ‘Direct Impact’ on Not-for-Profit Hospitals (Aug. 11, 2011), (last accessed, Aug. 17, 2012).
[6] S&P: Hospitals are Reaching the Limit of Efficiency, Cost-saving Measures (Aug. 15, 2012), (last accessed, Aug. 17, 2012).

More Articles by Rachel Rose:

HIPAA/HITECH Risk Assessments: Are the Standards Being Met?
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