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

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

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CAPITAL FORMATION AND MANAGEMENT The implementation of prospective payment for capital costs makes it more necessary than ever for healthcare financial managers to be able to creatively balance capital costs with risk. A new financial management tool -- the interest rate swap (a contractual agreement in which one party with a fixed interest rate payment liability and another party with a variable interest payment liability agree to trade those obligations)--is proving to be a solution for a growing number of hospital managers. This article describes the uses of interest rate swaps and discusses the variables to be considered when evaluating whether the benefits of an interest rate swap offset the additional risk.

For years, most hospitals issued long-term, fixed rate, tax-exempt debt. The only other option for many hospitals was tax-exempt variable rate demand bonds (VRDBs). In the VRDB structure, the interest rate paid to bondholders changes on a short-term basis (frequently weekly). In exchange for the lower interest rate, bondholders have the right to request that the hospital purchase the bonds on short notice (called a "put" or "tender option"). In order to protect themselves against this latter possibility, hospitals frequently purchase a letter of credit or similar enhancement from a bank or bond insurance company.

While these transactions are complex and have significant associated costs, hospitals issuing VRDBs have been able to take advantage of interest rates lower than those of fixed rate bonds in return for assuming more interest rate risk. Though there are new types of variable rate bonds available today, the VRDB remains the prototype and is by far the most common.

In the last several years, a number of new financial instruments have been developed to allow financial professionals to manage currency and interest rate risk, and diminish the volatility of commodity prices. Options, swaps, and futures have been widely used in the corporate, foreign exchange, and commodity markets. The considerable experience gained with swaps in the broader capital markets has shown that they can change the risk and interest expense profile materially for a given hospital, and swaps are gaining in popularity. Healthcare finance experts calculate that only $250 million in interest rate swaps for hospitals were executed in 1986; by 1992 that total had risen to $3 billion.

Only interest rate instruments are applicable to hospital finance today, and swaps are the most common instrument. Because only interest rate instruments are appropriate, all references to swaps in this article will be to interest rate swaps.

An interest rate swap is a contractual agreement in which one party with a fixed interest rate payment liability and another party with a variable interest payment liability agree to trade those obligations. Typically, a hospital executes a swap with a financial institution and is not directly exposed to any other hospital or corporation. (For this discussion, the financial institution is known as the "counterparty.")

In addition to being stand-alone instruments, swaps have also been integrated into the structure of bond issues. While these structures change the bond mechanics, the issues raised by the swap are similar to a stand-alone swap; accordingly, swaps integrated into bond issues do not change the analysis presented here in a material way. Swaps integrated into bond issues often require credit enhancement from bond insurers, even if a hospital might not otherwise use bond insurance, because these transactions are so complex and many bond investors wish to minimize default risk.

Uses of swaps

As implied in its definition, an interest rate swap can either be from fixed to floating or vice versa. As a result, the financial effect can be to transform existing variable rate payments to a fixed rate or to transform existing fixed rate payments to a variable rate. The uses of swaps include: 1) matching (variable) taxable interest earning assets with a similar amount of variable tax-exempt interest debt; 2) locking in low variable rates when interest rates are low or to take advantage of declining interest rates when those rates are high; 3) taking advantage of lower short-term interest rates; and 4) gaining the benefit of variable rate debt without the costs and complexity of the VRDB structure. It must be noted, however, that while swaps are a powerful way of managing risk, they should never be used as speculative instruments or without careful consideration of the risks.

Hedging cash. One result of the decline in rates at which hospitals are reimbursed (and the greater business risk hospitals have assumed) has been the understanding that hospitals need greater liquidity to prepare for "rainy days." Of the many benefits of more liquidity, the most relevant to swaps is that as interest rates rise, so does interest revenue from interest bearing assets. In addition, investments may earn interest at a rate higher than that paid on a hospital's tax-exempt debt. While there are important Federal arbitrage laws and regulations with which hospitals must comply in the context of a bond issue, if a hospital has substantial cash balances accumulated over time that are unrelated to any bond proceeds, the result of a swap from fixed to variable rate can be a positive cash flow that is a legitimate hedge of variable interest rate exposure with cash.