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

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

The risk in variable rate instruments is that despite the upward slope of the yield curve, the overall rate of interest paid is higher than it would have been if the interest paid was fixed before interest rates rose. However, the benefit of variable rate debt instruments is that, over time, they have historically accrued interest at a lower rate than comparable long-term debt instruments.

Variable rate exposure without the problems of a VRDB. Historically, the VRDB was the most common approach taken by hospitals to get the benefit of the upward sloping yield curve. However, a VRDB has a structural feature that causes difficulty for some hospitals. As previously noted, bondholders have the right to request the hospital purchase their bonds on short notice (a "put"). To manage the put, hospitals have traditionally purchased either letters of credit or bond insurance policies with bank liquidity facilities to assure that some other institution would purchase the bonds on the hospital's behalf, if necessary. The critical component of this structure is an obligation by a bank to buy the bonds if the bonds are put by the bondholders.

Typically, the bank agrees to extend a loan to the hospital in the event of a put. The remarketing agent will continually attempt to find new buyers of the bonds. If the remarketing agent is not successful, the bank's loan must be repaid over a much shorter period (three to seven years) than the original bond issue at a taxable rate equivalent to the prime lending rate, or even higher. This constitutes substantial risk for a hospital expecting to pay a tax-exempt variable rate over a 30-year period. In addition, the fees that banks charge for these facilities have been increasing dramatically, and the bank repayment period in the event of a put has been shortening from years to months. For any VRDB issue, the hospital is exposed to the possibility that these banking arrangements may not be renewed or may be extended on less favorable terms. These potential changes in bank practices have made a VRDB a less attractive structure to gain the benefit of short-term interest rates than it was in the 1980s.

In recent years, new variable rate bond structures that avoid some of these concerns have been developed, but these new structures raise new problems in their place. The issues described thus far in this article are all bypassed in fixed-to-variable swaps, since the variable interest rate is based on an index and there is no put feature. There are no free lunches, however. Hospitals that enter into swaps are exposed to new and different risks, as described below.

How swaps work

Though the mechanics of swaps are simple, the simplicity of the structure can be deceiving. Swaps, as previously noted, can be either fixed-to-floating or floating-to-fixed. In either case, one party expects to pay a fixed rate that is determined when the swap is executed and is not subject to change. The other party expects to pay a variable rate that is determined based on an index.