In roughly nine months, Community Medical Centers went from an outcast in credit markets to a sought-after investment with a surplus of eager investors.
Back into the pool
After a lending drought, healthcare borrowers are itching to dive into the credit market. As the market eases, even low-rated borrowers are finding the water's fine—for now
Editor's Note: This article has been updated with a correction.
Headquartered in Fresno, Calif., with three hospitals and ambitions to expand, the system became one of the first healthcare borrowers this year with credit at the lowest end of investment grade to successfully sell tax-exempt long-term bonds. Not only that, but the system asked borrowers for no small amount, $210 million, and scored an interest rate—5.72% on bonds that mature in 2039—that rivals those secured by financially stronger systems in recent months.
“We hit this one really well,” said Steve Walter, Community Medical Centers' chief financial officer, who said the system's 30-year bonds had six times as many investors as available supply. “Now we can start ordering steel,” he said.
Behind the Community Medical Centers' triumphant return to debt markets are investors that have grown restless for returns after panic last fall prompted a flight to the safest, most liquid investments, finance experts said. But supply of long-term municipal bonds used as financing by tax-exempt hospitals, colleges and universities and state and local governments has failed to keep pace with demand. The result has gradually pried open credit markets that froze in late 2008.
Community Medical Centers and 25-bed Wright Memorial Hospital, Trenton, Mo.—both of which went to markets in late September—appear to be the first healthcare borrowers rated BBB- to enter the long-term municipal bond market this year, according to a survey of recent deals by Citigroup and figures from Thomson Reuters.
The deals suggest the continued thaw has reached borrowers that have been cut off from capital since the credit crisis began, but healthcare finance insiders caution it may be too soon to tell. Anywhere from five to nine BBB- bond deals have gone to market each of the past four years, according to a Thomson Reuters review of debt rated by Standard & Poor's, though such deals accounted for a fraction of debt issued.
Wright Memorial issued $30 billion with 6.75% interest on bonds that mature in 2034. Arlan Dohrmann, managing director of the healthcare finance group for Stern Bros. & Co., said the deal reflects an improvement from tighter markets that were open to only the strongest borrowers in the first three months of the year. “There was no market at that point” for low-rated investment healthcare borrowers, he said.
For Community Medical Centers, the more auspicious market reduced interest expenses by $27 million from earlier projections, Walter said. He credits the bonds' positive reception to investor confidence in the system's construction project, which will expand the Clovis (Calif.) Community Medical Center, a 109-bed hospital in a high-growth community, and the timing of the debt issue. The system and its underwriters pushed the bond issue ahead by one week to take advantage of declining rates, a move that paid off, he said. “We really hit a sweet spot,” he said.
Benefits of Build America Bonds
Healthcare borrowers owe the more favorable conditions, to some degree, to congressional efforts earlier this year to ease the credit strain on state and local governments. Under the economic stimulus bill enacted in February, government borrowers such as school districts, universities, cities and utilities can temporarily borrow taxable debt with a federal interest-rate subsidy. The option's popularity—including among hospital tax districts—has significantly drained supply from the municipal bond market.
Since the first Build America Bond went to market in mid-April, state, county and other government borrowers have issued $33.7 billion in taxable debt as of Oct. 2, according to the U.S. Treasury Department, that otherwise would have been competition for tax-exempt healthcare borrowers vying for investors' attention.
That dwindling supply has come as cash has flooded into mutual funds that buy up tax-exempt bonds.
In 2009, through the first week in October, assets of mutual funds that invest in long-term bonds have surged by $60 billion, according to weekly figures collected by the Investment Company Institute, a trade group for investment companies. Investors have regained confidence and have started to pull out of low-risk, low-return money market funds, said Edward Malmstrom, a Merrill Lynch & Co. managing director who oversees its municipal healthcare group. “Eventually, people get tired of earning close to nothing,” he said.
The result—a lopsided municipal bond market with more demand than supply—has lowered interest rates and prompted investors to seek higher returns among weaker borrowers, easing access to credit that months earlier was too expensive for those with midinvestment grade credit ratings.
An opportunistic play
Now hospitals and health systems with plans to go to market are rushing to do so, healthcare finance insiders said. Andrew Majka, chief operating officer for healthcare financial advisers Kaufman Hall, said not one of the firm's clients, among them large U.S. health systems, has overlooked the favorable market.
Indeed, the lower cost of capital on bonds with fixed interest may prompt some to refinance other debt, known as variable-rate-demand bonds, that has emerged as a significant source of risk to balance sheets, he said.
Such bonds are sold in short-term markets, as often as daily or weekly, and investors have the right to unload the debt back to borrowers—or “demand” repayment—just as swiftly. Few health systems have cash to easily meet such a demand, so as insurance, borrowers typically line up banks to guarantee cash and credit. But bank consolidation and distress has translated into fewer of such guarantees, which often must be renewed within one to five years.
And investors have lost confidence in some healthcare bonds when banks have stumbled, pushing up interest rates. Such uncertainty has heightened the risk that no investors will buy the bonds, which leaves hospitals and health systems with no other option but to rapidly refinance or pay off the bonds, which is a potentially severe strain on the balance sheet (July 20, p. 12).
Unlike the market for fixed-rate bonds, variable-rate-demand bonds have enjoyed enviable interest rates this year. (The benchmark for such bonds that go to market each week has not exceeded 1% since Dec. 31, 2008.) But Majka said that variable-rate bonds' interest rates, historically, have hovered closer to 3%, or more after factoring in financing fees.
He said for some health systems, the volatility and risk associated with variable-rate bonds may outweigh what could prove to be a minor advantage on interest costs. “It's an opportunistic play right now,” Majka said. “For the first time in a long time, we have a compelling alternative plan of finance in the fixed-rate market.”
How long will rates last?
That remains unclear.
Interest rates may rise as borrowers return to the market and have already inched upward from recent lows, though they still remain historically attractive, said Andrew Pines, managing director in the healthcare finance group at Citigroup, which handled the Community Medical Centers' deal. He said the strength of the market rebound since early this year has been “dramatic.”
Hospitals and health systems have a backlog of deals that were delayed by credit upheaval in late 2008 and early this year. Some of the nation's largest health systems have moved to go to market in recent weeks. Catholic Healthcare West, based in San Francisco, announced plans to borrow $919 million, which will wipe out $264 million of the system's outstanding demand bonds, analysts with the New York ratings agency Moody's Investors Service said last week. In the process, the system will reduce by 28% its outstanding demand bonds to $936 million from $1.2 billion.
Meanwhile, Catholic Health Initiatives, based in Denver with 59 hospitals in 18 states, was scheduled to go to market last week with $1.3 billion, including $768 million in newly issued long-term bonds and another $495 million to refinance auction-rate and variable-rate-demand bonds, according to a Fitch Ratings report.
Majka said other forces could also steer interest rates upward, including fear of inflation; healthcare reform developments that appear unfavorable for providers; and a growing confidence in equity markets, which could lure investors away from bond markets. “As quickly as these rates came down, they can go in the other direction,” Majka said.
Malmstrom at Merrill Lynch said volatility since the housing meltdown has left markets more sensitive to risk and potentially more skittish in the event of any significant and unexpected bad news. Still, Malmstrom said that he expects the recent robust municipal bond market to continue through the end of the year and that borrowers shut out since last fall will return as long as interest rates hold.
Healthcare bankers cautioned that recent activity is no guarantee of investor appetite for lower-rated healthcare bonds.
Brian McGough, managing director of healthcare investment banking at BMO Capital Markets, said it is too early to tell whether the recent decline proves to be temporary or a sign of further loosening in municipal bond markets. “It appears the tone is improving for tax-exempt debt, but we'll have to wait and see,” he said.
Steve Proeschel, a managing director in healthcare public finance with Piper Jaffray in Minneapolis, said he expects the market's thaw to continue gradually. “All of the real and psychological damage that occurred over the last 18 months has not been entirely forgotten,” he said.
‘Just in case'
Charles Santangelo, chief financial officer and executive vice president of three-hospital Susquehanna Health, watched the municipal markets' auspicious turn with some apprehension as management rushed to complete the system's first bond deal in more than a decade.
Santangelo feared rates would reverse course before the three-hospital system could borrow $167 million to finance the sixth and final phase of a $230 million construction and renovation project taking place mainly at its 217-bed Williamsport (Pa.) Hospital and Medical Center but also at its 31-bed Divine Providence Hospital and 161-bed Muncy Valley Hospital, he said. “I wanted to hurry up and get this done and go to market, just in case,” he said. But such transactions require time for due diligence and negotiations.
The system, based in Williamsport, has spent roughly $70 million during the past three years on the project, but needed the additional debt for a six-story expansion to the hospital. The 250,000-square-foot patient tower, which is scheduled to open in 2012, will expand the hospital's emergency room and add 58 private patient rooms, he said.
Santangelo said the credit crisis disrupted the project from the outset. Susquehanna's first underwriter for the bonds, Lehman Bros., helped trigger the crisis that nearly toppled financial markets in September 2008 after the bank failed to avoid bankruptcy (Sept. 21, p. 6). As markets froze, he faced the prospect of a project without necessary financing, he said.
As markets began to defrost, Santangelo and the system's executives moved to secure bond insurance from one insurer not severely crippled by exposure to risky mortgages. Santangelo said as he worked to prepare the bond offering in July, the projected interest on the system's bonds was roughly 7.5%.
Instead, the bonds (rated A- from Fitch Ratings and BBB+ from Standard & Poor's) priced last week 5.9% after factoring in fees, even after executives decided to drop the insurance. The difference will save Susquehanna roughly $2.6 million per year, he said. “We're very, very pleased,” he said.
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