Why develop a debt policy? Consider the risks and rewards of variable rate interest and options for financing debt

Physician Executive, Jan-Feb, 2005 by Terence Pladson

Access to capital is a key issue for many organizations and developing a debt policy will help clarify your organization's options for debt financing, evaluate your tolerance for risk of interest rate changes and engage your board of directors with ownership and understanding of the policy.

Developing a policy to guide decisions also helps focus the plan on a long-range perspective of interest rates that can help guide appropriate decisions regardless of the short-term outlook.

Our organization has about $252 million of long-range debt. This includes $168 million in variable rate debt through a synthetic swap agreement with a major financial institution. Our organization issued fixed rate, 30-year, tax-exempt bonds at an average interest rate of approximately 5.7 percent.

At the same time we entered into a swap agreement with the Counterparty (JPMorgan Chase Bank) to receive a fixed interest payment of 5.47 percent and pay the current weekly Bond Market Association (BMA) Index. In order to receive a higher fixed interest payment on the swap, we also sold an option to cancel the swap at the first call date on the bonds. The remaining debt of $84 million is in fixed rate bonds with a range of 5 to 5.5 percent interest rates.

The opportunity to call in some of our fixed rate bonds and refinance them at either lower fixed rates or to convert this debt to variable rate options caused us to carefully evaluate our tolerance for interest rate risk and to develop our organization's debt policy.

Developing a debt policy requires a team approach, including understanding and support by the CEO, CFO and other key leaders as well as the organization's finance committee and the full board of directors. Networking with colleagues in health care is also helpful to assure the board that you are developing a policy consistent within reasonable guidelines.

Our organization's relationship with JP Morgan as the firm responsible for structuring our swap of the fixed rate bonds to a variable rate of interest made them a trusted resource in developing our policy. One of the key factors in developing our policy was the comparison of fixed and floating tax exempt long-term rates (see Figure 1) that compares the Revenue Bond Index (RBI) as a benchmark for long-term bonds and the Bond Market Association (BMA) Index which is a benchmark for tax exempt variable rate and the Rolling BMA which is the average of each weekly BMA and represents the average rate paid on tax exempt floating rate debt.

Of interest, the current spread between short-term and long-term debt is approximately 4.36 percent and the average spread over the past 15 years is 2.74 percent. The long-range spread between variable and fixed rate debt of 2.74 percent was a significant factor in our organization's comfort level with a plan to continue with a ratio of 70 percent variable rate debt and 30 percent fixed rate debt.

[FIGURE 1 OMITTED]

Data from numerous other health care organizations was also considered, particularly fiscal, year-end 2002 financial statements that included information on credit rating, long-term debt total, ratio of fixed to floating rate interest, debt to capitalization ratio, days cash on hand and their total of cash and investments.

Figure 2 shows the variation from 100 percent fixed rate debt for two institutions to 100 percent floating rate debt for one institution with a substantial amount of variation among other entities. Note that the Mayo Foundation had a ratio of 62 percent floating to 38 percent fixed and the Cleveland Clinic had a ratio of 70 percent floating to 30 percent fixed at the time of this report.

The current options for long-term debt financing include the following:

* Fixed rate tax exempt bonds with an estimated interest rate of 4.69 percent

* Fixed rate with a swap to variable rates estimated at BMA (currently 1.03 percent) plus 24 basis points, the difference between the fixed rate on the bonds and the swap receiver rate

* Variable rate bonds with a current estimated interest rate of 1.03 percent

* A total return swap to in essence convert our current fixed rate bonds to a variable rate of BMA plus 15 basis points

Developing a debt policy can help the organization balance the financing risk with other risk including the investment balance of its reserve funds. Organizations with a higher risk strategy for investment of its reserves may want a more conservative debt risk. Organizations that pursue more variable interest rate debt may be able to increase their operating income by interest expense reduction or achieve equivalent total income with a more conservative investment of their reserves.

The greatest risk of variable rate debt is the development of economic conditions that drive the variable rate interest to a level that significantly exceeds the long-term fixed interest rate. This can occur in economic conditions with high rates of inflation as occurred in the early 1980s, but which has not been a significant factor in the past 15 years.