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Understanding the Capital Formation Process
By Calvin W. Wiese CPA MBA
Credit enhancement is commonly used when issuing tax-exempt bonds. Credit providers guarantee the payments promised by the bonds, essentially co-signing. As a party with recognized credibility in the market, the bond provider agrees to make payments on behalf of the obligor in the event the obligor fails to make payments. The effect of this is that the credit rating on the credit enhanced instruments is higher than the underlying credit rating of the hospital obligor.
Credit Enhancement
Credit enhancement is primarily provided by bond insurers and commercial banks. Bond insurers issue insurance policies that cover the payments of principal and interest over the life of the bonds, usually up to 30 years. For this policy, the bond insurer is paid an upfront premium; typically in the range of 40 to 300 basis points (hundredths of one percent) applied to the total principal and interest payments. Effectively, the credit rating of the insured bonds becomes the credit rating of the bond insurer, typically ‘AAA’ or ‘AA,’ instead of the underlying rating of the hospital obligor. The credit enhanced bonds then are priced on the basis of the bond insurer’s credit rating resulting in lower interest rates. The difference between the interest rate based on the hospital obligor’s underlying credit rating and the bond insurer’s credit rating is the savings in interest payments derived by the insurance. The premium paid to the bond insurer is usually about two-thirds of the present value of this interest savings.
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Commercial Banks
Commercial banks issue letters of credit to enhance hospital obligations. Letters of credit basically provide that the issuing bank will make any principal or interest payments that the hospital obligor fails to make. Usually, letters of credit are issued for three to five years with “evergreen” provisions. Evergreen provisions provide the mechanism whereby the letter of credit can be extended for an additional year at each anniversary upon the agreement of the parties (not automatically). An important difference between bond insurance and letters of credit is the term: bond insurance covers the entire term of the bonds, while letters of credit cover less than the entire term (casting uncertainty on the credit enhancement provided by a letter of credit). Another important difference is the fee structure: letters of credit fees are paid on a quarterly basis, while bond insurance premiums are paid upfront.
Letters of Credit
Due to its short term, the letter of credit has to provide a “take out” mechanism that is exercised in the event the letter of credit is not renewed. This “take out” mechanism converts the underlying instrument into a bank loan with a short amortization — usually five to seven years — and a “prime plus” rate of interest.
Assessment
Letters of credit are most commonly used to support variable-rate tax-exempt instruments. These instruments are usually auctioned once a week and a new interest set for the next week. The interest rates are extremely low and make very favorable forms of financing. They do introduce interest rate uncertainty. Although the rates are low, there is no certainty that they will remain low, although they have never traded above about 6% in the 20 or so years they have been in the market. Because of this uncertainty, they are typically limited to something less than half the debt of a hospital.
Conclusion
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Filed under: Health Economics, Healthcare Finance | Tagged: Bond insurers, Calvin W. Wiese, Credit Rating Agencies, Hospital Bond Insurers, Hospital Credit, tax-exempt bonds | 2 Comments »
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