During the past year, there have been notable changes to capital markets conditions that have impacted financing alternatives for nonprofit health care and senior living organizations. After years of low interest rates, we are finally beginning to see rates rise in a meaningful way. This is because the Federal Reserve has increased the federal funds rate seven times since December of 2015, after effectively lowering the rate to zero in 2008. In addition, recent federal tax law changes have impacted the market for tax-exempt borrowers. Health care and senior living organizations need to be cognizant of current market conditions as well as the recent changes to the financing landscape, as doing so will enable these organizations to adapt and position themselves for success.
Impact of Tax Reform on Health Care FinanceSigned into law on December 22, 2017, the Tax Cuts and Jobs Act lowered corporate tax rates and had two notable impacts on health care and senior living borrowers, particularly those utilizing tax-exempt financing. First, the Act eliminated the ability of organizations to complete an advance refunding of existing tax-exempt debt with new tax-exempt debt. During periods of falling rates (like much of the past decade), many organizations used a tax-exempt advance refunding to lock in savings prior to the existing debt’s optional redemption date. As of January 1, 2018, however, organizations are no longer able to use tax-exempt proceeds to advance refund existing tax-exempt debt. Organizations must now use taxable financing, including taxable bonds, loans, and governmental agency finance like U.S. Department of Housing and Urban Development/Federal Housing Administration (HUD/FHA) and U.S. Department of Agriculture (USDA) programs, in order to advance refund existing debt or wait until the existing debt is currently refundable.
Secondly, during the past decade, many organizations used tax-exempt financing via a private placement, or direct purchase, of bonds by banks and other financial institutions (the “lender”). In some cases, the underlying bond documents linked the interest rate to the lender’s corporate tax rate via a “gross up” provision. Accordingly, the lender is able to increase the bond interest rate if there is a decline in the Internal Revenue Service (IRS)-stated corporate tax rates, so that the lender is able to maintain the same after-tax yield. To illustrate, assume that the initial fixed rate was 4% and that the lender’s corporate tax rate declined from 35% to 21%. Many gross up provisions were written such that the initial fixed rate is multiplied by the result of one minus the new tax rate, divided by one minus the original tax rate [e.g., 4% multiplied by (one minus 0.21) / (one minus 0.35)]. In this scenario, the organization’s interest rate would increase to approximately 4.92% as the result of changes to tax law. Gross up provisions do vary; therefore, organizations should review their bond documents and seek guidance from their bond counsel, financial advisor and/or investment banker as appropriate.
Yield Curve: Now vs. ThenThe most recent tightening cycle began in December 2015 with the latest increase in June 2018. Presently, two more federal funds rate increases are projected for the remainder of 2018, with three more penciled in for 2019.
The Fed’s decisions have considerable impact on the short end of the yield curve. Figure 1 illustrates the difference between the AAA general obligation bond yield curve as of June 28, 2017 and 2018 for bonds maturing between one and 30 years. The yield curve flattened as short-term interest rates increased more than long-term rates. For example, yields on one-year maturities increased by 61 basis points while the 30-year yields increased by only 20 basis points. Accordingly, the slope of the curve, as measured by the difference between the one and 30-year bond yields, is currently 145 basis points versus 186 basis points a year prior.
The upward shift in the AAA yield curve also impacted taxable rates and popular borrowing indices like one-month (1M) LIBOR and the prime rate. Over the past 12-months, 1M LIBOR increased by 89 basis points from 1.22% to 2.09%. As such, organizations with floating-rate debt tied to 1M LIBOR and the prime rate have experienced a noticeable increase in their interest cost. Given the slope and continued pressure on the short end of the yield curve via the Fed’s potential action, organizations may consider evaluating potential fixed-rate financing options to take advantage of long-term rates and eliminate interest rate risk. Additionally, since most variable rate structures are callable at any time, tax law changes prohibiting advance refundings probably do not apply.
Health Care Yields and SpreadsGeneral market health care yields remain favorable when compared to their historical averages dating to the beginning of 2008. As of June 29, 2018, the current 30-year yields for A and BBB health care were 3.58% and 3.90%, respectively. Likewise, the historical average yields for A and BBB health care were approximately 4.6% and 5.2%.
Credit spreads between yields for different credit ratings represent the additional premium investors charge over a benchmark yield. For health care and senior living organizations, the focus is typically on credit spreads between A and BBB health care yields and AAA general obligation yields. Presently, the A and BBB health care spreads are 0.64% and 0.96%. Since 2008, however, the average credit spreads for A and BBB health care credits were 1.07% and 1.65%, respectively (Figure 2).
Accordingly, for the general health care market, long-term rates for investment grade organizations are stable and relatively low. We also continue to realize narrow credit spreads. As a result, accessing long-term, tax-exempt fixed rates continues to offer attractive financing for health care and senior living organizations.
Supply and DemandSupply and demand of tax-exempt bonds also impact market conditions. As discussed above, tax reform pulled significant tax-exempt volumes forward from 2018 into 2017, as organizations raced to beat the changes impacting advance refunding rules. Total issuance (supply) through June 2018 is down nearly 19.5%, which can make new tax-exempt bonds relatively more attractive as investors (demand) have fewer buying opportunities.
Going forward, prudent health care and senior living organizations should keep a close eye on the changing market conditions, as doing so will enable them to modify financing plans and position themselves for a bright future. Submitted by Lancaster Pollard - Author: Kyle W. Hemminger
Bruce Lorenz, Chair