Effective January 1, 2018, the new tax code has both a direct and an indirect impact on health care systems planning to access capital, particularly those which utilize tax-exempt debt.
Tax-exempt debt is accessible to health care borrowers, but specifically limited to nonprofit, district, county, or municipally owned entities. Its defining characteristics are that investors do not pay state or federal taxes on the interest they receive from the borrower. In exchange for this benefit, lenders accept a lower interest rate from borrowers providing less expensive capital to qualified health care organizations.
How Will the Market React?
The new lower corporate tax rate may change the demand for tax-advantaged investments such as tax-exempt bonds. Historically, borrowers of tax-exempt debt could expect to pay approximately 67 percent of taxable rates (measured against the 10-year treasury rate). But if investor demand decreases, this percentage is likely to increase, resulting in higher interest rates. For example, if a taxable bond was priced at 7 percent for 30 years, then a tax-exempt bond would be 4.69 percent at the 67-percent discounted rate but 5.04 percent at a 72-percent discount. It remains to be seen how the market will react, but any financial forecasting should include a provision for higher rates for this reason as well as the rising interest rate environment predicted for 2018.
Elimination of Advance Refundings
A direct impact of the tax code is the elimination of advance refundings for tax-exempt bonds. Advance refundings allowed a borrower to refinance debt prior to the time at which the bonds could be refunded or paid off without any penalty (i.e., the call period). So if a call period was 10 years and in year 8 of the payback, interest rates were significantly lower than when the bonds were issued, an escrow fund would be set up and funded by new lower-rate debt until year 10, at which time the old bonds could be paid off entirely and the new lower-rate debt put in its place. However, while advance refundings were eliminated, the use of current refundings remains intact.
A current refunding is simply refinancing the debt after the 10-year call period has expired. The benefit to the borrower of both advance and current refundings is the ability to borrow at a lower interest rate or to change their debt portfolio in some way, such as lowering annual debt service payments by extending the payback period or changing debt covenants.
Other viable financing options remain available in the taxable debt markets. These well-established, taxable borrowing programs, generally government supported, provide cost-effective alternatives to tax-exempt debt. They include HUD mortgage insurance, USDA Guaranteed Loans, or Direct Bank Placements.
Changing Capital Markets
The capital markets are accustomed to change and have adapted to policy changes not just in the tax code but in reimbursement and other key policies affecting health care organizations. It will just be a matter of time before we see new adaptations in debt structures and their pricing to continue to provide health care organizations affordable access to capital.