Why You Should Actively Manage Your Derivative and Debt Portfolios

Recent legislation may drive the tax-exempt cost of debt higher

by Kyle Patino

The Tax Cuts and Jobs Act of 2017 (the “Act”), effective January 1, 2018, will have a direct impact on the balance sheet of health systems. Regardless of the source of capital, one notable impact is that the Act is driving the tax-exempt cost of capital higher.

Bank Lending

Since the credit crisis in 2008, bank lending has become a major source of capital for tax-exempt organizations, and in many instances, has significantly supplanted the variable rate bond market. This lending, commonly referred to as a direct purchase loan, typically affords the lender certain protections against a change in the corporate tax rate. These protections can be explicit, such as a margin rate factor (well defined formula), or more general in nature such as gross up language. 

Borrowers should review their loan documents to assess the impact the Act will have on them. The result is that this type of lending is now less valuable to banks that benefitted from the tax deductibility of interest in a higher marginal corporate tax rate environment. Regardless, it is widely expected that banks will exercise the rights afforded to them. 

As borrowers assess the impact of the Act on their underlying cost of capital, they should also assess the impact the Act will have on any interest rate hedges they currently have in place if no corresponding change is made. If the floating rate of the related hedged debt changes, basis risk will be realized by the borrower with a fixed payor swap, whereby the borrower pays fixed and receives a floating rate. Typically the floating rate received under a swap matches with the floating rate paid on the direct purchase loan. 

However, if the floating index for the direct purchase loan is increased, as a result of the Act and when no corresponding change is made to the related interest rate hedge, the borrower will be under hedged. The quick formula for the under hedged position is the percent of LIBOR received (under the swap) divided by the new percent of LIBOR paid (under the bank loan). So if the rate on the loan is 80% of 1-Month LIBOR and the swap is 67% 1-Month LIBOR, then only 83.8% (67%/80%) of that debt is hedged (assuming it started at 100% hedged). Said another way, the borrower now has 16.2% of floating rate debt subject to interest rate risk. 

Borrower Options

There are two common options that can be deployed by borrowers. The first and easier, is to do nothing. Given the credit strength and composition of assets, many health systems can easily absorb the rate risk. However, if in the aggregate the variable rate exposure is higher than desired, borrowers can amend the interest rate swap to match the new underlying floating rate paid to the bank under the bank loan. Keep in mind that this amendment is akin to a new swap on the unhedged portion, meaning that if rates rise, waiting to amend the hedge will result in a higher rate than acting immediately. 

It is important to actively monitor and manage one’s debt and derivative portfolio. Policy implications can and do impact the composition of the balance sheet with the unintended consequence of moving a borrower along the risk spectrum. Active management can ensure the desired risk and debt composition.

Kyle Patino
CAIA, Managing Director and Senior Vice President
Derivative Products Group, PNC Bank, N.A.


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