Short-term interest rates, which have been slowly rising, are expected to rise again this week as the markets prepare for Federal Reserve System Chairman Alan Greenspan to step down. But the changes in the financial markets should have little bearing on hospital borrowing, in part because of healthcare's newfound willingness to employ complicated risk-taking tactics, including what is known as the interest-rate swap.
To the contrary, hospitals, which are becoming increasingly sophisticated in their capital financing strategies, are growing impervious to the vagaries of short-term interest rates, industry experts said.
Financing volume for not-for-profit healthcare systems reached a record level in 2005, fueled in part by recapitalizations spurred by adoption of corporate finance strategies, according to David Cyganowski, managing director and healthcare co-head at Citigroup.
More significant than the rising short-term interest rates is the "rare and exciting phase of a `flat' yield curve" in which short-term rates are nearing long-term rates, Cyganowski said. "The impact is that it has changed how hospitals are borrowing-not how much," he said. "Healthcare systems are adopting more corporate finance strategies. They've become much more sophisticated. ... They are now actively employing the same type of strategies that corporations have used for years." The healthcare systems exploiting the flat yield curve to its fullest "are those which take a strategic perspective of their capital structure."
For example, the rise of short-term rates from as low as 1% less than five years ago to about 3% now has increased interest costs at Trinity Health, but it has "not changed our strategy, which is long-term," said Edward Chadwick, Trinity's chief financial officer and senior vice president. In trying to minimize the volatility in interest costs, the system, which has a debt portfolio of $2 billion, targets a 50-50 mix of fixed and variable-rate debt, Chadwick said. Rather than "time the market," the system issues debt every year as part of a five-year financing plan, he said.
Among other things, the flat yield curve is increasing the attractiveness of "swaps" to hospitals, and more specifically, synthetic fixed-rate debt, which is the far more prevalent type of swap for hospitals right now, according to Cyganowski. Swaps are private financial contracts between two parties who agree to exchange interest rates for a specified period. The transaction acts as a hedge against fluctuating interest rates and diversifies debt liabilities.
At the end of the agreed time, one of the parties winds up owing some money to the other party depending on what happened to fixed and variable interest rates over that period. "It's a way to engineer your liability apart from the bond market," said Robert Fuller, principal at Capital Markets Management Corp., a financial adviser to not-for-profit hospitals. "It's a way to continuously adjust assets and liabilities-that's why hospitals take it on."
Hospitals can now reduce financing costs by as much as 0.75% per year with "floating to fixed swaps," which on a $100 million in borrowing generates $750,000 in annual savings, according to Cyganowski.
Still, "There are lots of reasons not to do swaps. Most important, if you don't understand what you are doing, it can be dangerous because what you are really doing is a trade for shaping the risk profile of your hospital," Fuller said.
Swaps have been prevalent in the corporate world since the early 1980s, but "they have really been picking up steam" in the not-for-profit hospital market only in the past couple of years, he said. Last year, nearly every hospital deal he was involved in included at least one swap, he said.
The use of variable-rate bond structures by healthcare organizations, including the issuance of variable-rate bonds coupled with a floating-to-fixed-rate swap, has grown dramatically over the past several years, according to a report by credit rating agency Fitch Ratings. In 2000, approximately 45% of all healthcare debt issued was structured as floating-rate debt. By 2004, that portion grew to 63%, Fitch said. Fitch said it expects the trend to continue because of "more sophisticated asset-liability management strategies" and the growing acceptance of interest-rate swaps by healthcare organizations.
As variable-rate bonds take up larger portions of hospitals' debt portfolio, hospital managers are also looking for ways to manage or diversify the inherent risks, Fitch said. Last year, the University of Pittsburgh Medical Center inaugurated an alternative, tax-exempt variable-rate security designed by Goldman Sachs and until now familiar only in the corporate world.
The security, known as extendible municipal bonds, or X-tenders, was adapted from a successful product in the taxable markets called X notes, said Susan Benz, managing director and head of the healthcare group at Goldman Sachs. Designed for organizations with strong credit ratings of "A" or better, Benz said the X-tenders allow hospitals to diversify their debt liabilities at a time when many of the investment banker's clients have a large amount of variable-rate debt because of the increased use of swaps.
"I think Goldman was looking for a health system that they knew was creative and didn't mind going first," said Tal Heppenstall, UPMC's treasurer.
X-tenders are sold without the backing of bond insurance or a bank's letter of credit, eliminating banking costs. Unlike auction bonds, they also are designed to be sold to money market funds, opening up "a huge amount of buyers," Heppenstall said. UPMC, which issued $105 million in X-tenders in November 2005, paid a slightly higher interest rate than it would for conventional variable-rate bonds, but saved a lot on bank fees.
Benz said Goldman Sachs is "in discussion with several other healthcare issuers and (anticipates) it will grow considerably in the following year."
Overall, UPMC is now "rebuilding our balance sheet" as part of a global capital strategy with the aim of maintaining 125% of its $2 billion in outstanding debt in unrestricted cash, Heppenstall said. Right now, the system has a little over $2 billion in unrestricted cash. The debt portfolio includes five swaps for a total of $260 million in debt; 60% of the debt is in traditional fixed-rate bonds.