Variable Rate Demand Bond Structures after
Tax Reform

Third Quarter 2018 - PNC Healthcare Capital Markets Update

Not-for-profit healthcare borrowers may turn to traditional bank debt as a source of capital to foster growth and expansion. The loan agreements tied to these tax-exempt bank direct placements typically include a provision to protect the lending institution in the event of a change in corporate tax rate. The protections can be explicit, such as a margin rate factor (well- defined formula), or more general in nature such as gross-up language.

Since the Tax Cuts and Jobs Act of 2017 took effect, banks have begun exercising the protective provisions triggered by the drop in the corporate tax rate. As a result, borrowers have seen rising interest costs associated with bank direct purchase loans.

To combat this reality, borrowers are seeking low-cost alternatives to replace newly higher-cost bank loans. Variable Rate Demand Bond (VRDB) structures have emerged as an efficient way to refinance the loans adversely affected by tax reform.

Overview of VRDBs

Variable Rate Demand Bonds are floating rate obligations sold in the public markets that are particularly attractive to money market funds and investment advisors. VRDBs typically have a nominal long-term maturity of 20-30 years, but a short term interest rate that is most often reset daily, weekly, or monthly. Tax-exempt VRDBs are benchmarked to the Securities Industry and Financial Markets Association (SIFMA) and taxable VRDBs to the Intercontinental Exchange London Interbank Offered Rate (LIBOR).

VRDBs commonly incorporate a tender option that allows investors to “put” the bonds back to the borrower on the interest reset date. The tender option requires the borrower to repurchase the bonds from the investor at the full face value of the bond, plus accrued interest.

When a VRDB’s tender option is exercised, the remarketing agent appointed to the transaction is tasked with remarketing, or re-selling, the VRDB to new investors. This remarketing process allows the borrower to avoid a sudden liquidity event in the event of a tender.

Addressing a failed remarketing

In the event of a failed remarketing, whereby the remarketing agent fails to find investors to purchase the bonds, the borrower must have a liquidity source in place to pay those investors who have tendered their bonds. Accordingly, VRDBs typically have a contractual source of liquidity, which can take the form of a bank direct letter of credit (LOC), a stand-by purchase agreement (SBPA), or, in the case of particularly creditworthy borrowers, self-liquidity. Investors value a contractual liquidity source as security and reassurance that the borrower will be able to pay its obligation.

Cost Benefit of VRDBs

Favorable short-term rates – VRDBs are long term obligations priced to a short-term index. The current delta between SIFMA and LIBOR rates, shown in the chart below, allows for the potential refunding of LIBOR-based bank loans with tax-exempt VRDBs priced to SIFMA.


(Source: Bloomberg as of October 10, 2018)

Risks of VRDBs

Interest Rate Risk — The risk of an increase in short-term interest rates. In the case of a rise in interest rates, borrowers may experience a higher cost of borrowing than if fixed rate bonds were issued originally.

Remarketing (“Put”) Risk — The risk that the remarketing agent is unable to find purchasers for tendered securities. Remarketing agents do not have an obligation to purchase the tendered VRDBs. If the remarketing agent is unable to find investors for the tendered securities, the tender agent or trustee would draw on the LOC or SBPA in an amount equal to the principal amount, plus accrued interest of the securities.

Rollover Risk/Renewal Risk — The risk that a suitable liquidity bank facility cannot be secured at an acceptable price to replace the existing liquidity facility upon termination or expiration of the contract period.

Liquidity Risk — The risk that, in the event of a failed remarketing, the bank that has agreed to provide the LOC or SBPA fails to honor its obligation to support the VRDBs.

Default Risk — VRDBs usually are not secured by the assets of the borrower, and are instead subject to the LOC or SBPA provider honoring its obligation. However, repayment of principal and payment of interest ultimately is dependent upon the borrower.

PNC in the Market

PNC Capital Markets LLC (PNCCM) is one of the leaders in the placement and remarketing of variable rate demand bonds. Based upon PNCCM’s experience and understanding of the structural requirements of investors, in particular money market purchasers, it maintains the ability to deliver competitive market pricing. At the end of Q2 2018, PNCCM ranked as the 7th largest remarketing agent by number of issues and 10th largest by par.

Top 10 Dealers of Variable Rate Demand Bonds Dealer Rankings by Number of Issues Dealer Rankings by Par* Rank Dealer Number of Issues Rank Dealer Par Amount ($ millions) 1 BOFA MERRILL LYNCH 585 1 BOFA MERRILL LYNCH $29,146.98 2 CITIGROUP GLOBAL MARKETS 496 2 J.P. MORGAN SECURITIES 26,113.27 3 J.P. MORGAN SECURITIES 463 3 CITIGROUP GLOBAL MARKETS 18,495.24 4 WELLS FARGO SECURITIES 440 4 WELLS FARGO SECURITIES 15,654.47 5 RBC CAPITAL MARKETS 267 5 GOLDMAN, SACHS & COMPANY 11, 545.41 6 GOLDMAN, SACHS & COMPANY 227 6 MORGAN STANLEY 10,652.32 7 PNC CAPTAL MARKETS LLC 215 7 RBC CAPITAL MARKETS 10,209.88 8 STERN BROTHERS & COMPANY 196 8 BARCLAYS CAPITAL 10,123.20 9 BARCLAYS CAPITAL 173 9 US BANK 6,725.13 10 MORGAN STANLEY 172 10 PNC CAPITAL MARKETS LLC 4,438.01

(Source: Thomson Reuters Municipal Market Data 6/30/2018)

PNC Capital Markets LLC and PNC Bank N.A. have been involved as underwriter, remarketing agent, and liquidity providers in VRDB transactions for all types of not-for-profit organizations, including healthcare systems. Select recent healthcare transactions are highlighted below. We continue to monitor client and prospective clients’ portfolios to identify potential savings opportunities.

$88,505,000

University Hospitals Health System

Series 2018B

Sole Underwriter / Remarketing Agent / LOC Provider

$23,680,000

West Virginia University Health

2018 Series D

Sole Underwriter / Remarketing Agent / LOC Provider

$65,665,000

OSF HealthCare

 

Series 2018C

Remarketing Agent / LOC Provider