Health systems consider returning to financing derivatives as a result of 2017 tax law

Advance refunding—issuing a tax-exempt bond to refund an existing one—used to be a not-for-profit hospital’s screwdriver, a tried and true instrument for managing debt found in just about every chief financial officer’s toolbox.

 Since the Tax Cuts and Jobs Act disallowed that strategy at the beginning of 2018—a change many are still working to reverse—financial advisers, bankers and lawyers predict this year some not-for-profit health systems will consider a portfolio of alternative maneuvers they may not have thought about before. That would include so-called Cinderella bonds, multistep derivatives and plain old vanilla swaps.

“From an economic standpoint, and just a pure market standpoint, I would say it’s probably a pretty good time to look at these kinds of alternatives,” said Eric Jordahl, a managing director with Kaufman Hall.

Some of the moves are relatively simple—like taxable advance refundings or direct placements with banks—while others are more complicated. Interest rate swaps, in which two parties agree to exchange generally fixed interest rate payments for variable-rate payments, were shunned after health system investors took a hit from them during the Great Recession.

More esoteric methods involve selling a bond that won’t be paid for until close to the call date of the existing bond it’s designed to pay off, or selling a taxable bond that becomes tax-exempt in the future. Experts believe systems may pursue the latter strategies, which tend to carry more risk, for bonds that are up for call in 2020 or 2021.

“It’s not any sort of legal gymnastics to get around what Congress implemented,” said Brian McGough, a managing director in Ziegler’s healthcare investment banking practice.

“These alternatives have always existed. But with advance refundings going away, folks have revisited some of those tools and probably will continue to look at those alternatives from time to time,” he added.

Because most bonds in the municipal market are callable within 10 years of being issued, and lots of health systems issued tax-exempt bonds in the higher interest rate environment of 2010, now is a good time to plan a refinancing strategy, McGough said.

For investment bankers, the tax law’s changes, just like other major regulatory shifts, have meant they’ve had to go beyond the traditional financing strategies they offer their health system clients. 

But with the potential rewards of such maneuvers come the risks inherent with betting on future interest rates.

In the case of a method called forward-delivery bonds, where tax-exempt bonds are sold with a future delivery date that’s within 90 days of the call date of the existing bonds they’re refunding, there’s the risk that an unexpected change in federal tax law could prevent the bonds from ever being delivered.

Ninety days is the period that separates an advance from a current refunding. A bond issued to refund a prior bond more than 90 days before the existing bond’s call date is considered advance refunding. If it’s issued within 90 days of the call date, it’s a current refunding.

Typically with those products, the bondholders aren’t willing to take on interest rate risk that’s more than a few years out—18 to 24 months is a common time frame—because of the possibility that interest rates could fluctuate in the future, said Bob Capizzi, a partner with Chapman & Cutler. The longer the window between the sale and issuance dates, the higher the interest rate investors will demand in exchange for taking on higher risk, he said.

Antonio Martini, a partner with Hinckley Allen in Boston who advises not-for-profit health systems on bond issues, said he has found the one-year time frame to be more common.

“With forward-delivery bonds, the longer the period of time that has to lapse, the more risk there is to the underwriter that’s making the bond that things will go sideways, rates will radically change and the bond won’t have the anticipated value it does today.”

An alternative approach called synthetic refunding is typically a forward-starting swap. Unlike a plain vanilla swap, in which the two parties agree to swap interest-rate payments starting in days or weeks, the parties to a forward-starting swap sign the agreement months or more before the swapping takes place. The intent is to lock in the current interest rate. When the swap terminates, the borrower issues bonds to refund existing bonds within the legal cutoff of 90 days before their call date.

The method can take two forms. In one scenario, the borrower enters an interest rate swap with a forward effective date to lock in the current fixed interest rate and, when the swap terminates, issues fixed-rate bonds to refund the existing ones within 90 days of their call date.

In the second structure, a borrower enters into a fixed interest rate swap, but issues variable-rate refunding bonds within 90 days of the existing bond’s call date. The swap remains in effect and the borrower effectively pays a “synthetic” fixed rate through the swap, and the swap counterparty pays the variable rate on the refunding bonds.

Under what’s known as a Cinderella bond, a bond is issued on a taxable basis and then, on a future date outlined in the agreement, converts to tax-exempt. Exactly how that happens is murky. “You sprinkle fairy dust on it,” joked Henry Grady, an industry manager for SunTrust Bank’s healthcare specialty division.

In actuality, he explains, it works almost like a private placement, where the conversion is agreed upon in the documents.

Others say one of the risks of that strategy is that the conversion won’t take place, in which case, the borrower would be stuck with a taxable bond.

Rich Moore, a tax partner with Orrick in San Francisco and president-elect of the National Association of Bond Lawyers, said many in the industry are hoping for more explicit guidance from the U.S. Treasury Department over what’s needed for a bond to convert from taxable to tax-exempt, which is currently an area of legal uncertainty. He said he doesn’t expect to get that in the near future.

“If that’s achieved, I do wonder whether we’ll see more Cinderella bonds done,” he said.

If regulators were to scrutinize any tactic, some say Cinderella bonds would be the first to get a closer look.

If Cinderellas or other strategies were eliminated, Grady said, bankers would come up with new strategies that would yield the same outcomes, so long as everything is aboveboard and documented.

“Where there is a will, there is a way,” he said.

Larger health systems are more likely than smaller ones to have the capacity to take on riskier, lesser-known borrowing strategies. None of the experts interviewed for this article named a health system currently engaged in such strategies on the record, although several said they knew of systems that are considering them.

The Government Finance Officers Association recommended health systems use “extreme caution” when considering derivatives. Borrowers may see this as an opportune time to lock in the current market’s low interest rates, but the hectic political environment makes that a risky proposition, said Emily Brock, director of the association’s Federal Liaison Center. 

“It could seem like the perfect time, but also, we have a very hard time predicting what’s going to happen next week,” Brock said.

Investment banks have a conflict of interest in that they hope to benefit financially from such transactions, and so might be overly enthusiastic without clearly stating the risks, she said. 

“I think there is a significant amount of information that is left unsaid when not-for-profit healthcare institutions do hear from their financial institutions,” she said.

It’s common for bankers’ presentations on the subject to focus more on the benefits of such products than on the downsides, Capizzi said.

“Frankly, I think bankers, unlike the financial advisers, are pitching products that they want to see the borrowers invest in,” he said.

For a number of not-for-profit health systems, the idea of using interest rate swaps is a nonstarter because they got burned on the derivative strategy during the 2008 financial crisis. At that time, some systems were forced to post millions of dollars in collateral if any fixed rates on their swaps were higher than the market’s prevailing interest rates.

“I candidly feel like there are still a lot of people that are awfully spooked by what happened to them,” said Moore, of the National Association of Bond Lawyers.

On the other hand, the end of tax-exempt advance refunding is prompting some borrowers to take a renewed interest in swaps, especially in the context of a forward-starting swap.

Grady said while he realizes the collateral requirements generated animosity around swaps, he views the current setting as, “a new wrinkle on an old product.” 

A number of not-for-profit borrowers, including health systems, rushed out their bond issuances before the end of 2017 so they wouldn’t have to comply with provisions of the Tax Cuts and Jobs Act that took effect in 2018.

Issuance was up 62.6% in the final quarter of 2017 over the prior-year period, according to the Securities Industry and Financial Markets Association.

As a result, the municipal market remains in something of a lull. Municipal issuance fell 25% from 2017 to 2018, from $448 billion in 2017 to $338.3 billion last year, below the 10-year average volume of $363.8 billion, according to the securities industry association.

However, Steve Sohn, a senior vice president with Kaufman Hall, said that may change as borrowers approach 2020 and 2021 call dates.

“That’s why we think it’s actually a pretty timely discussion to have now to think about what happens to ’20 and ’21 types of bonds,” he said.