Synthetic refunding: a financial tool for a low interest-rate environment - Treasury Management - a hospital can benefit from using synthetic refunding instead of advance refunding

Healthcare Financial Management, May, 2003 by Eric Jordahl, Kevin T. Ponton

Does the following situation sound familiar? Interest rates are at their lowest levels in decades. You and everyone you know have refinanced their home mortgages.

What's more, your boss or your board or both have done all they can to lock in the lower rates for paying the hospital's outstanding debt.

But there is one nagging problem: a relatively high-rate series of bonds appears to be stubbornly immune to refinancing. Either it's not currently callable, or legal counsel says the tax law prevents an advance refunding (something about a "prior refinancing"), or rates are so low that no escrow on earth can earn enough to produce savings.

There's nothing you can do about it. Or is there?

Synthetic Refunding

It might be time to consider a "synthetic" refunding. This type of funding attacks higher coupon debt that is not currently callable and cannot be advance-refunded due to tax law limitations or because the negative arbitrage in the refunding escrow erodes or eliminates savings.

In a traditional advance refunding, new bonds are sold, and the bond proceeds are used to purchase an escrow fund composed of U.S. Treasury securities with earnings sufficient to pay the principal, interest, and call premium on the refunded bonds. Savings from the advance refunding are reduced by the amount of any negative arbitrage (escrow reinvestment rate minus the average coupon on the refunded bonds) in the escrow fund. All other things being equal, the amount of savings falls as negative arbitrage increases. If the negative arbitrage gets to be too large, even a significant reduction in interest rates between the refunded and refunding bonds might not produce any savings.

In the current market environment, earnings rates on U.S. Treasury securities have fallen faster and further than interest rates on municipal bonds, increasing negative arbitrage and, consequently, reducing the savings benefit from the refunding issue.

A synthetic refunding may be the best response to these circumstances. In synthetic refunding, the hospital negotiates a "forward swap": it agrees today to enter into a "fixed-pay" swap contract that will start at the call date of the outstanding bonds. On that call date, the following events will occur:

* The swap starts, and the hospital makes a fixed-rate payment to a swap provider and receives, in exchange (hence the name "swap"), a variable-rate payment. The fixed rate is established at the time the forward swap is originally entered into (today), and the variable rate equals either the BMA index (an index of floating rates compiled by the Bond Market Association) or a percentage of London InterBank Offered Bate (LIBOR; in the exhibit on page 104, we have used 67 percent of LIBOR).

* Simultaneously, the hospital issues floating-rate, current-period refunding bonds that, when combined with the swap, produce a net fixed-rate refunding at the interest rates in effect when the forward swap was originally entered into (today).

The hospital's net fixed swap rate equals the sum of the "spot rate" plus a forward premium. The spot rate reflects normal pricing considerations such as the hospital's credit, the duration of the swap, and prevailing swap rates. The forward premium is essentially equal to the swap provider's cost of carrying the forward commitment through the call date. Consequently, the forward premium is higher for longer call dates. The forward starting swap rate will always be higher than what the hospital could achieve in the spot market, but the increase should be reasonably limited to the provider's actual cost of carrying the forward commitment. Added to the forward premium is the cost of the credit enhancement and liquidity needed to support the floating-rate refunding bonds. The aggregate net fixed rate to the hospital equals today's spot rate plus today's forward premium plus variable-rate program fees established at the issuance of the floating-rate bonds.

When the call date arrives, the hospital will have several alternatives, depending on how the general level of interest rates has changed from the level today.

If interest rates have moved above the net fixed rate, the hospital has two choices. The first choice is to proceed with the original transaction. Issue floating rate bonds that, when combined with the fixed-pay swap, produce a net fixed rate that is lower than could be obtained in the then-prevailing fixed-rate market.

The second choice is to terminate the swap for value. In a rising interest-rate environment, any swap transaction is of greater economic value to the party paying a fixed rate. When interest rates increase, a fixed-income investor's holding (in this case the swap provider who receives a fixed-rate payment) declines in value. If rates have moved up, the hospital has the option of terminating the swap and receiving a termination payment from the provider equal to the difference between the notional amount of the swap and its market value. Upon receipt of the termination payment, the hospital then has the option of either leaving the existing bonds in place or proceeding with a fixed-rate current-period refunding.