Returning to the market are traditional investors such as wealthy individuals and institutions, including mutual funds, which have fueled a municipal market rally since January that has slowly thawed access to capital for healthcare borrowers.
Meanwhile, bond insurer distress and bank consolidation have limited access to the credit and cash guarantees that borrowers relied on to woo investors for variable-rate debt during the heady years before the credit crisis.
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We continue to see an evolution of the marketswhat we call back to the future, says Andrew Pines, managing director in the healthcare finance group at Citigroup, one of the industrys largest underwriters, noting the absence of the boom-era leveraged investors and the big resurgence of retail or individual buyers. Individuals snapped up an average of 40% of three tax-exempt bond deals Citigroup recently brought to market, he says.
Institutional investors have also fueled demand as investors seeking stability and stronger yields returned assets to mutual funds (May 25, p. 14). The crisis in financial markets that erupted last September drove investors to exit funds for safer and more liquid investments, depleting tax-exempt mutual funds by roughly $14.5 billion before panic subsided in December 2008, according to the Investment Company Institute.
But investors returned in January seeking higher returns without the stock markets volatility. The steady influx of cash since the beginning of the year has handily erased the prior years loss. As of May 27, more than $23.7 billion in cash has been invested in municipal bond mutual funds, the investment institutes figures show (See chart).
Meanwhile, federal efforts to stimulate the economy have kept some supply out of municipal markets. Through 2010, governments may issue taxable debt that offers bondholders a 35% tax credit as an alternative to tax-exempt bonds under the American Recovery and Reinvestment Act of 2009. That has drained $10 billion from municipal markets, according to Citigroups estimates, depleting municipal investment options even as investors flood back into the market, which has pushed rates lower for remaining tax-exempt borrowers, including not-for-profit hospitals and health systems.
Ed Ollie, chief financial officer for New Hanover Regional Medical Center in Wilmington, N.C., says that the recent favorable shift in fixed-rate markets, combined with uncertainty in the variable-rate markets from the banking industry woes, prompted the 646-bed hospital to refinance $120 million entirely as fixed-rate bonds. Earlier in the year, fixed interest rates remained unaffordable for the solidly rated system, and executives were prepared to divide the refinancing between fixed- and variable-rate markets. The strategy shifted as rates began to slide in April.
Ollie says that the move buffers New Hanovers 3.5% operating margin against interest-rate volatility and the risk of trouble among banks that back bonds in the alternative variable-rate markets.
Because bond insurers are struggling, borrowers have increased their demand for letters of credit, a joint guarantee of cash and credit from banks even as banks own troubles have limited their capacity to guarantee bonds.
Bank consolidation has also narrowed the number of players, which can limit options for investors seeking to diversify their exposure among banks. As the financial market crisis unfolded, Wells Fargo & Co. swallowed Wachovia Corp., Bank of America Corp. bought Merrill Lynch & Co., and J.P. Morgan & Co. consumed Bear Stearns Cos. Meanwhile, UBS exited the municipal bond market.
New Hanover closed its bond deal in early June with an effective interest rate of 4.9% on 22-year bonds. Retail investors bought roughly $30.8 million of the refinanced debt. We wanted to saturate the retail market as much as we could, Ollie says.
Retail buying has become a major factor in demand for tax-exempt bond sales, says Peter Bruton, a managing director in municipal finance with underwriter RBC Capital Markets.
The money, like water, has got to go someplace, says John Cheney, managing director at financial advisory firm Ponder & Co. in Baltimore. Cheney notes that investors in search of higher returns without the uncertainty of the equity markets have poured money into municipal bonds since January, improving access to capital, though less so among borrowers with lower investment-grade credit ratings. Municipal investments also appear attractive to investors who believe income tax rates will remain the same or increase, he says.
There are signs that investor confidence may be extending to riskier borrowers. In mid-May, University Medical Center, Tucson, Ariz.the University of Arizona College of Medicines teaching hospitaljoined a small number of borrowers with weaker credit ratings to successfully return to long-term, fixed-rate debt markets since last years credit upheaval.
In January, the 351-bed hospital abruptly halted plans to go to investors for $61 million after the economys quickening slide in late 2008 pushed interest rates unaffordably high for the hospital, which is rated Baa1 by Moodys Investors Service. Liquidity had pretty much left the building, says Kevin Burns, the hospitals CFO.
The modestly sized bond financing was needed to complete a six-story expansion project that began three years ago. Construction has nearly doubled the hospitals emergency room and trauma center and will add 88 private beds to the hospitals adult intensive-care, medical and surgical capacity. But UMC needed another $55 million to finish the interior for three remaining floors to increase its pediatric capacity to 96 beds, which are expected to open in 2010.
Patience paid off in May. University Medical Center seized on ebbing interest rates as investors continued to pour cash into municipal bond markets through mutual funds. The system also expanded its retail marketing effort, and individuals accounted for 10% of its investors, Burns says.
Despite the markets more favorable conditions, borrowing continues to be more costly, burdensome and riskier than before the crisis began.
Interest rates on University Medical Centers 30-year debt came in lower than the more than 8% that investors demanded in January, he says. The hospitals effective interest rate was 6.6%. For every 1 percentage point shaved off the interest rate, the hospital saved $600,000 a year on debt- service costs, Burns estimates.
Such rates are favorable under current conditions, but higher than the roughly 5.2% interest on the University Medical Centers 2005 bonds, Burns acknowledges. But three years ago healthcare borrowers enjoyed a boom in attractive rates. Burns says that the hospital went to investors in May and moved to take advantage of the lower rates before the opportunity disappeared. If the bet proves wrong and rates continue to fall, University Medical Center will refinance, he says. Where will this end up? Burns asks. I dont know.
Ed Malmstrom, managing director and manager of the healthcare group at Merrill Lynch, says that retail appetite continues to be strong but has eased as interest rates have slid. Whether borrowers will continue to enjoy lower rates may depend on the economys recovery and demand from borrowers eager to enter debt markets, he says.
Fear of inflation has recently pushed U.S. Treasury rates higher; historically, tax-exempt bond rates rise with taxable notes, though less sharply, Malmstrom says. And should a surge of deals go to market, leverage could again shift toward investors and away from sellers, Malmstrom says.
InterHealth Corp., a not-for-profit organization in Whittier, Calif., that owns 409-bed Presbyterian Intercommunity Hospital and physician practice Bright Health Physicians, saw an opportunity to take advantage of retail investors more pronounced presence in municipal bond markets during a recent refinancing, says Mitchell Thomas, the systems senior vice president and CFO.
The system opted to market $58 million of its $280 million refinancing as long-term, fixed-rate bonds and targeted wealthy individuals as buyers in an effort to nudge interest rates slightly lower and avoid the debt service reserve fund that institutional investors demand, Thomas says. Not having a requirement to set aside cash for debt service would free $6 million on the balance sheet. We were hoping to go entirely retail, he says.
The strategy fell short when InterHealth entered the market alongside Catholic Healthcare West, San Francisco, a similarly rated but significantly larger and more diversified system, Thomas says. He credited the competition for the fact that retail investors bought only 40% of InterHealths fixed-rate bonds. Institutional investors claimed the rest, with slightly higher interest rates and demand for a debt service fund.
It was the 2008 upheaval in short-term municipal bonds and tight credit markets that forced InterHealth back to the markets this year. Late last spring, InterHealth secured a one-year loan from seven banks to temporarily buy up its bonds from the auction market, which collapsed in February 2008 as bond insurers exposed to the nations housing bubble faltered and investors fled. Interest rates on auction bondswhich were historically low, but reset as often as daily as bonds changed handsskyrocketed as the market seized. Borrowers saw interest rates climb to as high as 12% to 15% from 2% to 3%.
Thomas says the system received a one-month extension on the bridge loan as it negotiated refinancing to exit auction markets, which also included $222 million in variable-rate bonds. Thomas says InterHealth worked with existing lenders to secure credit and liquidity guarantees needed to issue the bonds, which require such backing because of an option that allows investors to unload, or put, bonds back to borrowers with as little as one days notice.
Banks lending constraints have made such guarantees harder to secure. InterHealth parceled out its debt among seven lenders to cover the entire $222 million. Thomas notes the bank guarantees are good for three years.
Borrowers face risk that stressed banks wont renew backing or that distress will undermine investor confidence, spurring investors to abruptly unload the bonds and forcing hospitals or health systems to rapidly pay back the debt.
One bank recently devised bonds that continue to offer investors an out, or put, but give borrowers the option of seven months or 13 months notice to find new buyers or refinance. The Securities and Exchange Commission recently notified Citigroup that regulators would not take action against money market funds should they acquire bonds in the newly designed debt structure.
We were very thankful that we were able to restructure and finally get out of our auction debt and diversify our debt portfolio, Thomas says.