The Rise, Fall, and Possible Return of Variable-Rate Demand Bonds
Variable-rate demand bonds, wildly popular in the high-inflation period spanning the 1960s through the 1980s, could be returning as an attractive financing option for healthcare organizations.
Hospitals operate today in an age where low interest rates are the norm and the Federal Reserve Board wonders how to stimulate inflation without letting it run away. The current economic and hospital leadership, like much of the baby boomer generation, has been profoundly influenced by the events of the inflationary era of the 1970s and 1980s.
The financial markets responded to the inflationary era by developing products that offered alternatives to the high cost of fixed-rate borrowing. In the tax-exempt market, the solution brought forth was the creation of the variable-rate demand bond (VRDB), which rapidly became the preferred financing tool for healthcare borrowers that wanted an alternative to double-digit fixed-rate borrowing. The use of VRDBs became commonplace and reached a high-water mark in 2008 when it represented almost one-third of total municipal bond issuance. Then, almost as quickly as they rose to prominence, VRDBs virtually disappeared. A number of factors were at work in contributing to the decline of VRDBs, not the least of which were regulatory rules governing the banks that had fueled the growth of the VRDB market with cheap credit.
Healthcare borrowers, in particular, were quick to recognize the value of the VRDB and its variations and became major users of the product even after its popularity waned. The disruptions in the market that occurred later had a clear impact on many hospitals as they were forced to convert insured variable-rate debt to different forms. Hospitals that continue to rely on the current modes of variable-rate debt will again be affected when those modes change
Although inflation is not an immediate issue, it is the stated Federal Reserve policy that it intends to raise interest rates to more “normal” levels, which assumes close-to-historical averages. If that does occur, current forms of variable-rate borrowing could change and future healthcare borrowers could be affected in myriad ways.
The Emergence of the VRDB
The development of the VRDB was a direct response to a prolonged period of inflation that began in the mid-1960s and extended well into the 1980s. In 1980, the Federal Reserve funds rate hit 20 percent—a historic high point. By any definition, it was a tumultuous period.
The advent of double-digit interest rates prompted the financial community to develop products that would, in some way, manage the high cost of conventional fixed-rate debt. Fixed-rate borrowing remained the preferred form of hospital financing, although hospitals always had relied on bank lending to support their short-term capital needs. The transformation from a short-term lending market to a long-term bond market was a major step in coping with the inflationary times, but to gain acceptance from the market, first and foremost, there had to be a set of buyers with an interest in variable-rate debt.
Almost coinciding with the start of the VRDB market was the emergence of the money market fund. Money market funds started in the 1970s as an alternative to the low interest rates offered by banks and savings and loan associations. Initially, these new funds focused on investments in commercial paper and short-term U.S. Treasury notes and bonds. In an environment where rates were rising, returns on these investments quickly outpaced rate levels offered by their competitors. As a result, money market funds grew rapidly and emerged as the perfect consumer of Wall Street’s new product.
The first issuance of VRDBs was in the late 1970s. The key to the development of the product was cultivating appeal to both buyers and sellers. For the sellers, the VRDB offered short-term rates within the context of a long-term issue. In the context of health care, a hospital could finance a major project on a variable-rate basis without the need for a reissuance. For the buyers, the creators of the VRDB provided a put option that enabled the buyer to exit at any time upon notice of the intention to put. The put option was essential to tying down the biggest category of prospective new buyers, namely the money market funds.
Essential Components of the VRDB Market
There were two other essentials needed for the VRDB market to take off, the first being the creation of a market index to provide a benchmark to monitor pricing and the second being credit to support the put option. The creation of that market index came in 1981 when the J.J. Kenny Company, an inter-dealer broker of municipal bonds, introduced the J.J. Kenny Index, which was based on a survey of five broker dealers with issues with 30-day rates and the highest short-term ratings. Rates were reset every Tuesday for a Wednesday effective date. The J.J. Kenny Index provided weekly rates to the variable-rate market for almost 11 years before it was replaced by the Public Securities Association (PSA) index, which was based on a survey of 250 to 300 weekly variable-rate issues with the highest short-term ratings. The PSA Index remains in effect today under the name of its successor organization, the Securities Industry and Financial Markets Association (SIFMA).
The second component of the new market was credit. From the very outset, highly rated financial institutions, including banks and insurance companies, viewed the VRDB market with great interest. Foreign banks, in particular, saw the new market as an opportunity to establish a U.S. presence. Moreover, bank risk standards varied widely across the globe, which meant foreign banks could frequently outprice their U.S. competitors. In 1986, for example, seven of the 10 leading providers to the variable-rate market were foreign banks.
By the end of the 1980s, VRDBs had become an integral part of the bond marketplace, with issuance rising from $706 million in 1981 to $12.609 billion 10 years later, peaking in 1985 with more than $54.7 billion of VRDBs issued in anticipation of the profound changes that occurred with the 1986 Tax Equity and Fiscal Responsibility Act. Healthcare borrowers were major participants in the 1985 and 1986 increased volume, particularly in the form of tax-exempt loan pools.
While the market had grown significantly, the international bank regulators took the first step toward creating standards for managing credit risk and establishing appropriate risk weighting of assets. In 1988, the Basel Committee on Banking Supervision (Basel I) published a set of minimum capital requirements for the purpose of fairly managing credit risk and determining appropriate risk weighting of assets. Basel I imposed international standards that would be applied to all of the principal participants in the VRDB market, which had the effect of leveling the field between U.S. domestic and foreign banks. It also set the stage for further regulatory intervention.
Growth of the Market
As interest rates returned to more “normal” levels in the 1990s and 2000s, the VRDB market continued to grow. Variations such as the rise of the auction-rate market and the use of municipal bond insurance coupled with stand-by bond purchase agreements provided alternatives to conventional bank-supported VRDBs. The new modes quickly gained acceptance and drove low-cost variable-rate debt to even lower levels. Hospital borrowers were among the biggest users of both insurance and auction-rate debt. With the adoption of the Basel I standards, pricing became more uniform, but foreign banks continued to represent a major presence. In 1997 foreign banks still represented six of the 10 leading credit providers to the VRDB market. A decade later, however, that figure dropped to one in 10 as the result of economic problems in Japan and Europe.
Contributing to the shift in credit providers was a second regulatory event in 2004, known as Basel II. Basel II set forth new regulations requiring maintenance of minimum capital requirements to ensure that banks had adequate capital reserved for their various lending, investment, and trading activities.
The volume of variable-rate debt remained high, reaching a peak in 2008 at almost one-third of municipal market issuance. Health care was a leading borrower; variable-rate debt accounted for 60 percent of a record year of issuance (over $57 billion) in 2008. Driving this surge in utilization was the demise of the auction-rate market in the calamitous 2007-08 period. As auctions failed and bond insurers lost their credit ratings, many of the auction-rate issues converted to VRDBs, creating a dramatic surge.
2008: A Massive Change Occurs
Despite such popularity of VRDBs, however, the events of 2007 and 2008 ushered in a number of changes that would lead to the near elimination of the market. First, there was a deterioration of credit among the major providers of credit. Virtually all of the major banks supplying credit to the VRDB market saw their credit ratings decline. Second, the market disruptions of 2008 triggered a call for more international regulation, which eventually became known as Basel III. Third, the municipal bond insurance market virtually disappeared and took with it much of the auction-rate market. Finally, the weakened financial condition of the U.S. economy led to a Federal Reserve policy to lower short-term interest rates to virtually zero for an extended period of time, which directly translated to multiple years of extremely low fixed-interest rates.
Perhaps the most important change driving the decline of the VRDB market was the imposition of the new risk-weighting standards known as Basel III. The new standards created additional capital requirements for risk-weighted assets that had the effect of increasing the cost of credit facilities, which were the principal source of support to the VRDB market. The new standards also increased the level of liquidity banks must maintain and—for banks deemed as “systemically important financial institutions”—set leverage ratios that had the effect of increasing the amount of capital needed to be held in reserve. In short, thanks to the new rules set forth in Basel III, the cost of extending credit via a bank credit facility became considerably more expensive.
Banks, however, did not exit the market altogether. Recognizing the weakness of the banks post 2008, the American Recovery and Reinvestment Act of 2009 expanded the definition of a bank qualified purchase from $10 million to $30 million for a period of two years and created a safe harbor for banks holding municipal securities up to 2 percent of total assets with the ability to deduct up to 80 percent of the cost of carry. These provisions, while temporary, offered some relief to banks and set the stage for a new product.
The new product was actually a variation on the old lending practice that had financed short-term capital needs years before. Rather than write a credit facility subject to the increased cost of capital and liquidity requirements imposed by Basel II and III, and weakened by the housing collapse of 2008, banks reverted back to direct lending. The challenge for the banks was making a loan look like the equivalent of a bond without including all of the trappings of a bond. With VRDBs, the banks were but one of a multitude of parties to the bond transaction, which also included underwriters, lawyers, rating analysts, printers, remarketing agents, and accountants.
Not surprisingly, the transactions involved significant time and upfront costs. To their credit, the banks determined that by characterizing the transactions as loans rather than bonds and holding the loans themselves, they could eliminate almost all the front-end costs because they weren’t selling to a bond-buying public. The banks entered into long-dated loans with periodic renewal provisions. The direct purchase loans could be fixed or variable and could be put in place with relative ease. Best of all, because they were loans, they were not subject to periodic valuation as would have been the case with bonds.
The new product was very well-received and all but eliminated the VRDB as a form of financing. Of course, there were regulatory concerns expressed that the loans looked a lot like bonds but weren’t subject to any of the regulatory requirements governing bonds. From the perspective of the borrower, however, the direct purchase was ideal. Up-front time and expense were minimal, and pricing was comparable. Variable-rate borrowing was priced at a spread over a percentage of either the one-month London Inter-Bank Offered Rate or SIFMA, and fixed rates were usually set to the tenor of the renewal period. For better credits, fixed-rate loans went as far as 10 years and longer.
The Relevance of VRDBs Today
The demise of the VRDB in the post-2008 era has been closely followed by a federal funds rate that is near zero. From December 2008 to December 2015, the rate remained in a range of zero to 0.25 percent. Since then, the rate has increased to its current range of from 1.50 t0 1.75 percent, and projections call for additional rate increases over the next two years, bringing the rate close to 3 percent. As a frame of reference, the federal funds rate on January 30, 2008, was 3 percent. Although long-term fixed rates do not move in lockstep with changes in the federal funds rate, it is certainly reasonable to expect that the economy is entering a period of higher interest rates.
At the same time rates have increased, the recent change in tax rates for banks will increase the cost of new direct purchases. The combination of higher interest rates and higher bank costs may lead back to the VRDB, at least in part. There is no question that the demands imposed on the banks by Basel III have made the cost of letters of credit and standby bond purchase agreements more expensive than previously, and that will have an obvious adverse effect on their use. Also, the relative ease in putting together a direct purchase transaction, in terms of both cost and time, will continue to make direct purchases an attractive alternative to the more complicated and time-consuming aspects of a VRDB.
Why, then, is there a future for the VRDB? It will begin with higher-rated credits that are recognizing that the VRDB is a path to lower-cost variable-rate debt without the need for a bank. For a select group of highly rated hospitals and health systems, the use of their own liquidity to support the issuance of VRDBs offers a lower-cost, long-term solution to permanent financing of variable-rate debt. Although direct purchase financing affords some advantages over a traditional VRDB, it is still limited to a specific term and pricing. That renewal risk is eliminated with the use of self-liquidity.
The number of hospitals and systems that can qualify for self-liquidity-backed financing is small, but their use of the product will revive interest in VRDBs as an attractive form of financing in a higher-interest environment—which, coupled with the new tax rates, may prompt the banks to move away from direct purchase financing to more profitable forms of lending. That move, in turn, may lead the banks to revisit the use of credit facilities, even at a higher cost, to meet the needs of their healthcare clients.
Although it is unlikely that VRDBs will reach the level of utilization achieved in the years prior to the 2008 crash, it is reasonable to expect that they will play an increased role in the tax-exempt marketplace as the higher interest rate environment becomes the norm.
Peter W. Bruton is managing director of Fifth Third Capital Markets Healthcare, New York.