Many of our nonprofit healthcare clients in recent years have financed or refinanced capital projects with variable rate demand bonds (VRDBs). In a typical transaction, a tax-exempt hospital requests a state or local governmental body to issue tax-exempt revenue bonds (with the governmental body not being responsible for payment of the bonds), and the proceeds from sale of the bonds are loaned or otherwise made available to the hospital. While the hospital is primarily responsible for repayment of the bonds, the creditworthiness and marketability of the bonds are enhanced by issuance of a letter of credit by a bank.
The interest rate on VRDBs is subject to periodic adjustment (generally weekly), and the bondholder typically has the right to tender the bonds for purchase by the hospital on short notice. If the "remarketing agent" cannot find a purchaser for the tendered bonds, the tendering bondholder is paid with funds drawn on the bank letter of credit. Accordingly, while VRDBs may have long nominal maturities, these features result in them being priced as short term obligations. Money market funds historically have been major investors in VRDBs.
The recent turmoil in the financial markets has adversely affected outstanding VRDBs in a number of ways, some expected and some not:
- Interest rates on VRDBs have generally reflected the financial strength of the letter of credit bank, rather than the strength of the underlying hospital borrower. Accordingly, as the financial condition of some banks has deteriorated (with accompanying reductions in their debt ratings), interest rates on hospital VRDBs supported by those banks' letters of credit have increased.
- Holders of VRDBs might tender bonds for purchase because of dissatisfaction with the interest rate or because of impairment of the letter of credit bank. Institutional investors may tender their VRDBs because of investment policies limiting their investments or holdings to instruments with at least a specified debt rating.
- Holders of VRDBs also might tender bonds for purchase because of their own liquidity needs. With the recent "run" on money market funds, the funds had an urgent need for liquidity to meet redemption demands by their investors. This resulted in increased tenders of VRDBs for purchase and reduced the universe of investors with an interest in purchasing tendered bonds. This has exerted further upward pressure on VRDB interest rates, even where the letter of credit bank remains strong.
- A common financial tool for hospitals utilizing VRDBs has been to synthetically fix the interest rate on part or all of their variable rate bonds by entering into a floating to fixed interest rate swap, either with a letter of credit bank or with another counterparty. Under such a swap, the hospital agrees to pay a fixed rate and the other party to the swap (the "counterparty") agrees to pay the hospital a variable rate, based on an external index. Frequently-used reference indices to establish the floating rate are based on historical correlations between VRDB interest rates, and the Securities Industry on Financial Markets Association's (SIFMA) weekly index of high grade VRDBs, the Bond Market Association (BMA) indices, or the London Interbank Offered Rate (LIBOR).
- Hospitals with LIBOR-based swaps (receiving interest payments based upon LIBOR rates in a swap transaction) have had unpleasant surprises in recent weeks. While the SIFMA and BMA indices are based on actual rates on similar VRDB securities, LIBOR is not. In recent weeks, increases in VRDB interest rates have exceeded (in some cases substantially) increases in LIBOR. In recent weeks, the rate payable to hospitals under a LIBOR swap by the floating rate payer counterparty in some cases has been significantly less than the VRDB interest rate due on the hospital's variable rate bond debt, effectively leaving it to the hospital to make up the difference between the interest rate changes in the LIBOR and VRDB indexes.
- Even though swaps based on SIFMA or BMA are based on actual interest rates in the same financial markets as the hospital's VRDBs, they are based, generally, on securities in a particular credit range. If the credit rating of the bank supporting a particular VRDB issue has deteriorated significantly, the interest rate payable by the floating rate payer counterparty (based on the SIFMA or BMA index) also could be less than the actual interest rate on the hospital's VRDB issue