Impacts of financial decisions
Tax-Exempt Debt Financing Update for Higher Ed and Nonprofits
Financial officers at higher education and nonprofit organizations are facing debt markets that are at historically attractive levels — and are entering those markets with the wisdom born from the 2008 credit crisis.
The borrowing environment for tax-exempt organizations is good right now. Rates are low, and investors are putting money into bonds.
If your institution or organization is considering tax-exempt borrowing to fund projects, a review of the past will help you understand the current borrowing environment and make prudent financing decisions.
Hard-learned lessons spark return to basics in borrowing and investing
For tax exempt borrowers, the municipal debt markets remained quiet and consistent for decades, until Lehman Brothers declared bankruptcy in September of 2008. Many borrowers had enhanced their issues with bond insurance, paying an upfront premium to obtain AAA ratings on their bonds. When insurer ratings fell below investment-grade levels, the bond insurance industry imploded. Higher education and nonprofit borrowers watched the ratings they had paid for on their bonds fall into junk territory.
The ratings of some large commercial banks were ravaged as well. Many borrowers had issued variable-rate bonds backed by letters of credit written by banks. Again, borrowers watched helplessly as bank ratings fell. The variable-rate bonds they had issued became unsaleable. Borrowers were made painfully aware of provisions in the fine print of letter-of-credit documents that forced immediate tender or accelerated amortization of principal.
This market turmoil led to a back-to-the-basics approach for borrowers and investors. Over the last eight years, borrowers have increasingly accessed the fixed-rate bond market using their underlying credit rating. In addition, bank loans have returned as popular funding sources, particularly for variable-rate or bridge financing. On the buy-side, institutional investors are dusting off their credit analysis skills that have lain dormant for so long, as they had come to rely on bond insurers and letter-of-credit banks to do their work for them.
Borrowers today enter the debt markets with some hard-learned lessons under their belt. They now know how important it is to read the fine print and understand the implications of term-out provisions, maximum rates, and covenants. They have also learned to spend time with legal counsel and discuss all of the worst case scenarios and to remove unpalatable terms and conditions. Some believe it might be advisable to take the deal that has the most flexible covenant package and default provisions even though it is priced higher.
Rates are still low and banks are lending again
The borrowing environment for tax-exempt organizations is good right now. Rates are low, and investors are putting money into bonds. In terms of approximate taxable rates, the 10-year U.S. Treasury bond yield is roughly 1.55 percent, and three month LIBOR sits near 0.69 percent (according to Bloomberg).
In terms of approximate tax-exempt rates, the Municipal Market Data (MMD) index of AAA-rated municipal bonds sits near 1.45 percent for 10 years, and 2.10 percent for 30 years. Over the last two years, the MMD curve has flattened at the long end and ticked up slightly at the short end (according to Thomson Reuters). The weekly tax-exempt floating rate index (SIFMA) currently sits near 0.41 percent (according to Bloomberg).
Tax-exempt borrowers issue debt at a spread to the tax-exempt MMD index in the same way that corporate borrowers issue at a spread to LIBOR or U.S. Treasuries. Because interest rates have been so low for so long, investors are finding fixed-rate higher education debt (especially in the lower-investment grade categories) attractive because of the yields, along with the low default rates. Net bond fund inflows, an important gauge of investor confidence in the municipal market, are a positive $37 billion thus far in 2016 (according to Lipper U.S. Fund Flows). As a result, credit spreads on bonds have narrowed, and borrowers have been able to negotiate favorable terms, such as forgoing debt service reserve funds, even at the lower end of the credit spectrum.
Commercial banks have largely regained their health and are actively lending. Borrowers seem to favor variable-rate loans over letter-of-credit backed bonds because of reduced uncertainty. Issuance of variable-rate demand bonds (VRDBs) has dropped from almost $120 billion in 2008 to less than $20 billion in 2015 (source: Thomson Reuters via the Bond Buyer). Removing the letter of credit from the debt structure eliminates remarketing risk and reduces renewal risk, as letters of credit tend to have shorter maturities than bank loans.
Banks continue to offer attractive fixed-rate structures as well. In some cases, banks will offer 20-year fixed-rate structures, which were very rare prior to 2008.
If your organization elects to take advantage of tax-exempt borrowing, these time-tested strategies can be smart choices.
- Use long-term debt instruments (30-year, tax-exempt bonds at a fixed rate) to fund capital projects with long useful lives, such as residence halls, where debt service certainty is important.
- Utilize floating-rate debt to fund projects with a shorter time horizon, or while waiting to receive gifts, or during a period of uncertainty when the final cost of a project is unknown. Floating-rate debt (variable-rate bonds or bank lines of credit) can be paid back at par without penalty.
- Maintain floating-rate debt in capital structure to reduce the overall cost of capital. One approach has been to match the amount of floating debt with floating-rate investments that are accessible to the operating budget.
In the second installment of this two-part article series, I’ll explain current financing vehicles in more detail.
How we can help
CLA’s higher education and nonprofit industry professionals understand how debt impacts your organization, and we can help with the difficult decisions surrounding debt financing.