Interest rate swaps: financial tool of the '90s - includes related article

Healthcare Financial Management, Nov, 1993 by Mark A. Woodard

Making judgments regarding future interest rate movements. As cautioned earlier, hospitals should not consider use of financial instruments for speculative purposes. However, the timing of any decision to issue debt always involves some judgment regarding the future movement of interest rates. For example, few borrowers would issue fixed rate debt today if they were reasonably certain that interest rates would decline tomorrow. Swaps are a sophisticated mechanism to take advantage of expectations of future interest rate movements.

For example, in the summer of 1992, long-term tax-exempt interest rates were lower than they had been in more than 10 years. There was the possibility that rates would go lower, but some hospitals believed that the summer of 1992 was a good time to change from variable rate debt to fixed rate debt. And as is known now, interest rates indeed did rise in the fall of 1992. While the decision to "fix" variable rate debt is surely a bet about future interest rate movements, a carefully considered decision to change from variable to fixed rate at that time was both prudent and financially beneficial. Swaps are one mechanism to make that switch.

Hospital managers also can use swaps if they believe interest rates will decline. In this scenario, swapping high fixed interest rate debt for variable rate debt as rates decline will lower a hospital's interest expense. If hospital managers make a decision that turns out to be wrong, interest expense will rise; this is the reason that hospitals should hedge with cash any variable rate exposure or the hospital should have sufficient financial resources available to cover the additional interest rate risk.

To take advantage of future interest rate movements, an organization must be able to act quickly. Swaps offer an advantage over other variable rate debt instruments in this respect, in that they can be executed rapidly. In contrast, VRDB's require a great deal of time and preparation to implement. By the time a VRDB is issued, an expected change in interest rate movements may have already occurred.

Taking advantage of lower short-term interest rates. The interest rate paid for a security over different maturities is called the yield curve, and the characteristics of the yield curve are well known: Short-term debt generally carries a lower interest rate than long-term debt. The reason for this is straightforward: In order to induce buyers to purchase longer term securities, purchasers must be compensated for potential increases in interest rates farther into the future. While the shape of the yield curve may change, and an inverted yield curve (where short-term rates are higher than long-term rates) occurs occasionally, historically a rising yield curve has been by far the predominant configuration.

Even though the nominal maturity of a VRDB is long term, it is a short-term debt instrument (a money market instrument) since the interest rate is reset regularly. As a result, hospitals with variable rate debt, either due to a swap or some other form of variable rate instrument, take advantage of the slope of the yield curve by paying interest that is usually in the lowest part of the curve. Historically, in a high interest rate environment the yield curve has been steep, so even when long-term rates were very high, short-term rates were not as high.