Is your balance sheet a sitting duck for interest-rate swings?
Some chief financial officers of major healthcare systems have discovered the answer is yes. However, they've found a way to immunize their balance sheets against precipitous changes in interest rates that could erode net assets.
Bob Kerr, vice president of finance at Mercy Health Systems in Cincinnati, is one of those CFOs whose balance sheet was out of whack.
About two or three years ago, Kerr contemplated adding some variable-rate debt to Mercy's portfolio of long-term liabilities. Mercy's investment banker, Bear, Stearns & Co., suggested he use "duration analysis" to help determine what proportion of the system's debt should be in variable-rate instruments. That analysis helped Kerr uncover "a very large disparity" in the duration of Mercy's assets and liabilities.
Duration analysis is a technique more commonly used in the savings-and-loan and insurance industries. But more hospitals, healthcare systems and managed-care plans are starting to apply it, investment advisers said.
"I think we are beginning to see a trend toward additional use of duration as a tool . . . for healthcare related enterprises," concurred Howard Rubin, vice president and director at Standish, Ayer & Wood, a Boston-based investment management firm. "I think it allows them to more comfortably assess risk in the liability structure and their equity structure."
According to The Credit Union Director's Guide to Asset/Liability Management, duration is "the time-weighted average maturity of the cash flows of a financial instrument." In other words, duration measures the impact of interest-rate changes on various assets and liabilities, taking into account the time value of money.
Duration calculations are expressed in years. Each asset on the balance sheet-from cash to endowments to capital improvement funds-has a duration. Likewise, durations can be calculated for each liability, including accounts payable and long-term debt.
Essentially, if a bond issued by a hospital has a duration of 6.5 years, that means it's going to take that amount of time for bondholders to get their money back. Duration also tells executives how the bond's value will react to interest-rate fluctuations. If interest rate increase by 1%, the value of the bond will decrease by 6.5%. If rates drop 1%, the bond's value rises 6.5%.
Changes in interest rates affect the liability side of the hospital's balance sheet in several ways. If the bonds are a fixed-rate liability and interest rates fall, the hospital's payments on those bonds will exceed the going market rate. If the hospital holds variable-rate debt and rates rise, its cost of capital increases, too.
The inverse relationship also applies to assets on the balance sheet. Say you have an endowment with a duration of 10 years. If interest rates rise by 1%, the value of the endowment fund slips 10%.
Using duration analysis, CFOs can better assess the net effect of interest-rate changes on the value of an organization's entire portfolio of investable assets and long-term debt. It enables CFOs to see how certain investment and capital financing decisions affect the entire balance sheet.
When Kerr put Mercy's balance sheet to the duration test, he found a significant "mismatch" of asset and liability durations. System assets, on average, had a duration of less than two years, while liabilities had a duration averaging nine years. That gap carries potentially negative consequences should interest rates fall (See chart).
Many not-for-profit healthcare systems, like Mercy, have capital structures based heavily on long-term, fixed-rate, tax-exempt debt with long durations, according to Miller Anderson & Sherrerd, a West Conschohocken, Pa.-based institutional investment management firm, which was acquired by New York-based Morgan Stanley in January 1996.
That mismatch is OK if interest rates rise, because net asset values also rise. But if asset durations are less than liability durations and interest rates tank, net asset values plummet.
To protect the value of Mercy's balance sheet from an interest-rate decrease, Kerr did two things. He extended the duration of the system's assets by putting more investment income in longer-term fixed-income securities. He also incorporated a much larger proportion of variable-rate debt, which lowered the duration of total liabilities.
Although the current interest-rate environment is favorable for investment-grade-rated healthcare institutions, variable-rate debt still can be issued at a rate that's a couple percentage points below long-term fixed-rate levels.
By more closely aligning asset and liability durations, "you stabilize your earnings," Kerr said.
"Duration is something that I think a lot of (healthcare system CFOs and treasurers) are taking a closer look at," said James A. Morrissey, a vice president with Miller Anderson & Sherrerd. Morrissey is co-author of a white paper titled Balance Sheet Management for Tax-Exempt Healthcare Systems, in which he discusses the use of duration analysis.
His view is that duration analysis can be a useful financial management tool for healthcare organizations, especially as they receive more revenues through capitation arrangements. Under capitation, healthcare organizations receive a prepaid amount before providing any services and receive no additional funds for costs exceeding the initial payment. So it's to their benefit to maximize the return on those assets.
But duration management is not, he emphasized, the only tool.
"The major point is not that systems should match asset and liability duration," Morrissey said. "Rather, it's that systems should be aware of these durations so they can maximize potential investment returns within institution-specific risk parameters."
Often, debt management and investment decisions are made independently of one another, without consideration of the big picture, Morrissey said. CFOs need to know the impact of those individual decisions on the entire balance sheet, given an institution's risk tolerance and operating strength.
Some institutions have a greater tolerance for risk than others, he said. That should be a consideration in weighing whether to lengthen total asset duration by investing more heavily in equities.
Consider Cleveland Clinic Foundation, among the nation's financially strongest healthcare institutions. In 1992, the venerable organization had allocated 40% of its long-term investable assets to equities, 45% to bonds and roughly 15% to cash, said Kevin Roberts, its treasurer.
In recent years, it has used duration analysis as a management tool, helping to support decisions to increase its equity allocation to more than 70%. Now, the clinic's investment committee is considering whether to increase its equity position to between 85% and 95%, said Roberts, a participant in Miller Anderson's and Morgan Stanley Asset Management's recent teleconference on healthcare balance sheet management, which drew more than 90 participants.
Cleveland Clinic doesn't attempt to directly match asset and liability durations but rather uses duration analysis as a tool to help size up the organization, Roberts said. With $700 million in annual revenues, some $250 million in debt and cash investment balances, strong market share and profitability, the clinic is financially poised to take far more equity risk than most healthcare institutions. And, over time, that risk should pay off in higher returns.