A Pennsylvania health care provider said derivatives have cut 30 basis points off the cost of a $55 million bond issue.
Wyoming Valley Health Care System Inc. said it was pleased with the outcome of the deal, which involved selling variable-rate debt and then immediately using a swap to convert into fixed-rate borrowing at a lower cost than would otherwise be possible.
Theodore Seiter, Wyoming Valley's treasurer, was confident the derivatives would not lead to any extra risk -- a danger highlighted by the crisis in Orange County, Calif. -- because Wyoming Valley brought in extra investment bankers, accountants, and lawyers to scrutinize the terms of the offering.
"We spent a lot of time doing our due diligence with our board of directors," Seiter said.
The $55 million offering was part of a larger $100 million bond sale put together by Connecticut-based derivatives boutique AMBAC Financial Services and Bear, Stearns & Co.
Proceeds will be used to renovate and expand two hospitals, principally Wilkes-Barre General Hospital; build new medical offices; expand the computer system; and defease a previous issue.
Seiter said the health care system was persuaded to look at derivatives by rising interest rates. Six months earlier, he said, the deal would have cost 100 basis points less.
But as a first-time derivatives user, he was concerned about the possibility of extra risk. In addition to the professionals normally employed, Wyoming Valley brought in a special counsel, a local CPA firm, and investment bankers Brown Brothers Harriman & Co.
Depending on which was cheaper for each maturity, the issue was split into conventional fixed-rate serial bonds, variable-rate bonds, and the swapped component.
Following this analysis, Wyoming Valley sold $25 million of serial bonds with maturities from Jan. 1, 1996, to Jan. 1, 2007, and coupons from 5.00% to 6.5%.
Derivatives took over from 2008 to 2024. For this period, Wyoming Valley issued amortizing variable-rate paper, then immediately carried out a swap with AMBAC. Under this agreement, AMBAC pays Wyoming Valley the variable rate owing on the bonds, canceling out the health care system's original variable exposure. In return, Wyoming Valley pays AMBAC a fixed rate of 6.83% on this $55 million portion of the series-A bonds, which were priced on Dec. 1.
Bear Stearns figured that a standard fixed-rate issue would have carried a 7Z coupon -- almost 30 basis points higher.
The final $19 million will be priced this week, Bear Stearns said. The coupon on the 30-year, amortizing, variable-rate series-B bonds will be set every five weeks by Dutch auction.
The swapped portion achieves lower costs because of the current structure of the yield curve, according to Mike Kelly, managing director of AMBAC Financial Services.
Short term, municipals generally trade at about 66% of treasuries, reflecting their tax advantage.
Long term, the gap narrows and munis rise to 80% to 95% of treasuries, reflecting the risk that tax rates may change in the future.
At the moment, sales by mutual funds have depressed long-term municipal prices and raised yields, narrowing the gap between munis and treasuries more than usual.
Kelly said this opens up the possibility of arbitrage, an opportunity exploited by swaps.
Kelly said AMBAC did not retain its exposure to variable rates but swapped back to fixed-rate in the taxable market. The boutique then only has to manage changes between Libor and the tax-exempt short-term marketplace.
To reduce its risks, AMBAC required Wyoming Valley to insure the bonds, raising the previous A rating from Moody's Investors Service to triple-A and costing 25 basis points.
An agent was brought in to cap the ongoing remarketing costs of variable-rate bonds at 10 basis points. The 35 basis points of extra costs were included in the calculation of the fixed swap rate.
Kelly said he expects the market for muni swaps, currently just 2% of issuance, to rise to as much as 10% in five years.
"When the market presents those kind of savings it would be difficult to justify borrowing in the fixed-rate market," he said.
Under present conditions, he added, issuers could readily achieve results similar to Wyoming Valley's. In high-tax states such as New York and California, the savings could be as much as 50 basis points, he said.