New notes bring fixed rates at lower prices - Financial Manager's Notebook - Column

Healthcare Financial Management, Feb, 1992 by Christopher T. Payne

A new tax-exempt bond structure offering dramatic savings was first used by a healthcare institution in February 1991.

The new structure, referred to as residual interest financing, consists of splitting a fixed rate issue into two different variable rate series of bonds that, when combined, always equal a set fixed rate. Bondholders receive variable rate securities, but the issuer pays a fixed rate.

In this financing structure, the first of the two bond series is referred to as Dutch auction notes (DANs). The second series of bonds is called residual interest notes (RINs). Interest rates on DANs and RINs always move inversely to each other. The rate the issuer pays is the average of the rates paid on the DANs and the RINs, giving the net effect of a fixed rate.

Dutch auction notes

Most hospitals are familiar with variable rate demand bonds (VRDBs), a common form of debt issued by hospitals since 1981. DANs differ from VRDBs because DANs cannot be put' (resold back to the issuer). In addition, DANs are usually repriced every four to five weeks through a Dutch auction mechanism. Since DANs cannot be put, issuers have no need for a liquidity facility. Holders of the bonds are dependent on either the auction process or their brokers to sell their bonds.

In a Dutch auction, the bond rate for the next interest period is the lowest rate offered by potential purchasers at which all bonds can be sold. For example, one issue of DANs has $20 million of bonds for sale at auction. When bids to buy come in, they are ranked from lowest yield to highest (see Exhibit 1). The new bond rate will be 5.2 percent for the next interest period because not enough bids were made at lower rates to sell all the bonds. Bidder number three win only get $5 million in bonds because orders for the two lower bids will be filled first, giving bidders an incentive to bid low. Bids higher than 5.2 percent would be rejected. If no bids are made at an auction, existing holders are required to keep their bonds, at a default rate, for the next interest period and until the next auction. The default rate is indexed to be slightly higher than the rate expected to clear the market in an auction.

Residual interest notes

The second half of this financing vehicle is composed of RINs, whose interest rate always changes at the same time as the rate on the DANs. The total amount of interest paid on RINs equals the remainder (residual interest) of the issuer's total interest payment on its fixed rate after interest is paid on the DANs.

The combined fixed rate on a DANs/RINs issue should always be somewhat lower than the comparable rate for conventional long-term, fixed rate bonds. For example, suppose the market for 30-year fixed rate hospital bonds is 7.25 percent, and a hospital wishes to issue $40 million in term bonds. The hospital could issue a combination of DANs and RINs at a fixed rate of 7 percent, split into two $20 million series.

The $20 million DANs series would be sold as described above, with a cap of 14 percent (double the fixed rate), necessary to assure that the hospital is not exposed to a rate higher than the set fixed rate. The cap should have no effect on marketing the bonds, since it is a customary feature of variable rate bonds.

For this example, the initial rate on the DANs is 5 percent. Simultaneously with the issuance of the $20 million DANs series, $20 million of RINs would be offered. The initial rate on the RINs would equal the sum of the fixed rate the hospital pays (7 percent) plus the difference between the 5 percent paid on the DANs and the 7 percent fixed rate (2 percent), or 9 percent. The rate the hospital pays on its $40 million debt will always be 7 percent, an average of the rates paid on the two series of bonds.

The hospital is not at risk for any swings in the market or any problems with the DANs auction. RINs holders assume these risks in return for the initial high interest rate. Exhibit 2 summarizes the effects of various potential moves in interest rates on various bondholders. The DANs rate is always set by the market for short-term rates, while the RINs rate moves inversely with the DANs rate so that the rate paid by the issuer remains fixed.

Holders of RINs can purchase an equal amount of DANs and link' their bonds, giving bondholders the fixed 7 percent interest rate. RINs holders are reasonably assured of being able to purchase DANs in order to link their bonds because they can bid 0 percent at the next auction. Once bonds are linked, it is immaterial how the interest is split because holders of both series are assured the issue yield, in this case 7 percent.

Market for DANs and RINs

DANs normally are purchased by buyers of short-term, variable rate paper. As would be expected, rates on these bonds tend to be slightly higher than rates on seven-day VRDBs, since there is no put feature. However, a liquidity facility is not required, and institutions rated in the A /A1 category or higher may not need any credit facility. Hospitals with lower ratings will probably be required to get some form of credit enhancement.