Municipal bond issuers, traditionally, have watched as the corporate bond marketemployed innovative financing techniques to meet changing needs. In this low-interest-rate environment however, muni issuers are finally waking up and smelling the coffee.
Particularly in the health care sector, issuers are increasingly examining a type offinancing feature known as payment or purchase in lieu of redemption as an alternativeto traditional refinancing. Industry sources have said many issuers executing dealsunder the payment-in-lieu-of-redemption structure are financial advisory clients of CainBrothers & Co.
James Cain, principal at the firm, noted, "We're aware of it, and yes, we are active onthese transactions." He declined to discuss the firm's role or comment further.
A number of issuers - including Group Health Cooperative in Washington, New Jersey-basedValley Health System, and the Burbank Public Financing Authority in California - havemet financing needs by utilizing variations on payment in lieu of redemption.
But such refinancing deals, though often attractive to issuers and investment bankers,do not sit well with insurance companies and some investors.
Insurance companies dislike the structure because they are unable to pull down premiumsas they would at the time of a traditional refinancing, while some investors balkbecause they believe they could get a higher price for their bonds by selling on themarket.
Jim Truess, chief financial officer at Group Health Cooperative in Washington State,said that one benefit of using a variation on the payment-in-lieu-of-redemption methodwas that the transaction costs were dramatically lower because there were no new bonddocuments and no new bond insurance. That made it a simple and easy way to takeadvantage of low interest rates, Truess said, adding, "We were pretty happy withexisting covenants."
Truess said that since the language in Group Health's bond covenants did not specify theuse of payment in lieu of redemption, it could not activate that feature. However itutilized a similar method through initiating a tender offer on about $50 million inSeries 1991 bonds in October 2002.
According to a bond attorney who declined to be identified because of the controversialnature of the product, the feature is often used in conjunction with a tender-optionbond program and a total rate of return swap. It can be structured to allow issuers tosynthetically refinance outstanding bonds - without new issuance - while simultaneouslymaintaining the attractive characteristics of the original bonds.
The feature can be tailored in a number of ways. Some issuers are able to take advantageof low interest rates and possibly swap an existing higher fixed-rate debt to a lowervariable-rate debt, the attorney said. Others use it to avert new insurance costs orretain longer maturities on previously issued bonds. This type of feature can attract,among others, health care entities that have increasingly encountered difficulties inobtaining bond insurance on new debt, due to the credit deterioration in the sector andthe reluctance of some bond insurers to provide new insurance.
If interest rates rise, the financing may need to be unwound, the attorney said. Theissuer would be using the structure to achieve lower interest rates, but if rates rise,in a worst case scenario, it could end up with the same high-coupon bond it hadinitially, according to the attorney. As a result, the structure could evaporate whenrates rise.
Termination payments may or may not be applicable, depending on the nature of thetransaction and how the termination occurs, Group Health's Truess said.
The attorney also noted that other risks include those inherent in any swap deals,including counterparty credit risks. In addition, the players must ensure that there areno tax questions surrounding the structure or the tax-exempt ownership of the bonds. "Ifyou do it right, it is not a problem; if you do it wrong, it could be," he said.
For the most part, insurers stand to lose from the structure. "For the insurancecompanies, most bond deals are called before maturity, so that's gravy," oneinstitutional investor said. "But if the bonds are not officially defeased, theinsurance company cannot take down unearned premiums, so they still have to accessprofits over a prolonged period of time." On the other hand, he added, when issuers dorefunding, this accelerates the earnings capability so the insurance companies have"big" years.
Dreyfus Neenan, equity analyst at Morningstar Inc., said that immediately earning theunearned premiums at the time of a refinancing is like "a little bit of cream on a cake"for the insurance companies, because they earn all outstanding premiums. In addition,any risk for the maturity of the bonds is eliminated.
Peter R. Poillon, first vice president at Ambac Assurance Corp., and Mike Ballinger,spokesman at MBIA, declined to comment.
Group Health's Structure
In October 2002, Group Health put a tender offer on the Street to purchase its bonds ata slight premium of 101% of par. Group Health retained Cain Brothers as financialadviser.
The issuer acquired in excess of 90% of the bonds, at 101% of par. The balance notacquired by that method were called and redeemed. The purchased bonds were then placedinto a trust and used as collateral for issuing new variable-rate bonds.
The underlying bonds pay an interest rate of 7.25%. The trust pays a variable interestrate, which is tied to The Bond Market Association index. Group Health Cooperative thenentered into a total rate of return swap with Lehman Brothers. The BMA swap rate closedat 0.70% yesterday.
Group Health paid the cost of funds for the trust plus a spread, Truess said, decliningto provide a specific figure.
The structure is an alternative to traditional refunding methods. However, purchasingthe bonds in conjunction with creating the tender-option bond program and the total rateof return swap, is "not a direct and perfect replacement" for a traditional method,Truess said. It made "tremendous economic sense," but it has a different set of risks.
An issuer needs to be in a good position to assume those risks. In a traditionalrefinancing, an issuer pays off its principal and interest on the original bonds. Inthis type of synthetic refinancing, there are counterparty risks and the term of thetransaction may not be for the full duration of the bonds, so it may require subsequenttransactions, according to Truess.
Group Health also applied the same type of structure to some $4 million to $5 million inbonds issued in 1988 that had maturities ending in 2005. In 2002, the bonds werepurchased, placed into a trust and entered into a swap agreement last year. Lehman andCain were also used to structure that deal.
Savings Bonanza
Valley Health System, based in Ridgewood, N.J., also utilized this kind of syntheticrefunding. According to Richard Keenan, chief financial officer of the hospital system,a primary reason Valley Health opted for this route over a traditional refunding wasbecause it could be completed within a much shorter time frame, decreasing thepossibility that interest rates would rise and thereby wipe out the potential costsavings.
"When rates dropped precipitously about a year and a half ago, I started thinking aboutrefinancing," Keenan said. "But once before, I had the problem of doing a refinancingand getting part of the way through the due diligence process and all the documents andall the work involved, and rates moved away from me and the whole thing had to beshelved," he added. "I didn't want to see that happen again."
Valley Health System made a tender offer for $25.71 million in revenue bonds sold by theNew Jersey Health Care Facilities Financing Authority in 1989 on behalf of Society ofthe Valley Hospital. Bondholders agreed last summer to tender $14.6 million of the bondsout of the $25.71 million Valley Health bonds outstanding.
Using Cain Brothers as the dealer-manager for the tender offer and Morgan Stanley to setup the trust that would allow Valley Health to make short-term floating-rate interestpayments on its debt rather than higher long-term rates, the hospital system was able torealize $2.1 million in cost savings, Keenan said.
The hospital was also able to achieve lower debt service payments without all the costsassociated with doing a refunding, he said.
In April this year, the hospital system again embarked on another tender offer for thebonds that remained outstanding. On July 1 of this year, Valley Health accepted thetenders for another $7.4 million in bonds. Keenan estimates that combined with the costsavings realized from the first tender offer, Valley Health saved a total of $3.5million. "This is, I think, a more elegant way of going to variable-rate debt," he said.
Investors holding some of the 1989 bonds might disagree. (See related story on page 30.)
BURBANK's Bounty
The Burbank Public Financing Authority has also implemented purchase-in-lieu-of-redemption refinancing. In February, the authority sold $87 million in bonds, in part topurchase a portion of outstanding 1993 tax allocation bonds of the Burbank RedevelopmentAgency for its Golden State Redevelopment Project. The BPFA deposited the proceedsneeded for the purchase in lieu of redemption in an escrow. The trustee, Wells FargoBank, will call the 1993 bonds on the call date of December 1, 2003, and use theescrowed proceeds to purchase the 1993 bonds on that date. The trustee, on theauthority's behalf, will hold the bonds from that point until maturity.
According to the minutes of a Dec. 17, 2002, public hearing of the BPFA, the mechanismwould preserve the advantage of maintaining the existing 2024 maturity date related tothe 1993 Golden State bonds, while enabling the issuer to benefit from the low interestrates available in the market. The yield on the 1993 bonds was approximately 6%, whilethe new bonds carry a yield of approximately 4.33%.
According to Peter Ross, principal at Ross Financial, financial adviser to theauthority, under state law, if the authority issued traditional refunding debt, thefinal maturity of the bonds would have to be 2020. Since the outstanding bonds mature in2024, the shorter maturity associated with the traditional refunding approach would haveadversely affected the annual cash flow benefit achieved through its ability to retainmore of its debt service allocation.
The payment-in-lieu-of-redemption approach allowed the agency to maintain the existingmaturity of the bonds and effectively achieve the cash flow benefits in each year in theform of up-front savings that could be used for new capital projects. Overall, thetransaction generated about 13% in net present-value savings. For tax purposes, thetransaction is treated as a refunding, he said.
Brian Quint, partner at Quint & Thimmig LLP, which acted as bond counsel on the newlyissued bonds, confirmed that the issuer was able to realize cost savings from therefinancing while maintaining the longer maturity.
Jacob Fine contributed to this story.
