In A Nutshell...
- Assured Guaranty is the only active hospital bond insurer left in the game
- Bond insurance works when the present value of debt service savings exceeds the premium
- The downgrade has had little effect on Assured-backed bonds
- Insurance is still an option to consider for hospitals in the 'BBB' category.
In March 2012, almost a year before last month's downgrade, Moody placed Assured Guaranty under Credit Watch. At the time, Assured was rated 'Aa3'. On January 17, Assured was downgraded to 'A2' with stable outlook. The insurer is currently rated 'AA-' with stable outlook by Standard & Poor.
As financial advisors to hospitals planning to issue tax-exempt debt in the public markets, either to refund existing debt or fund new projects, we keep close tabs on the debt markets. Recently, we were asked how the downgrade has impacted bond insurance as an option. So here is a brief overview of the situation, how bond insurance works, what's changed, and how to approach bond insurance for hospitals seeking to minimize the cost of debt.
Long before the Moody downgrade, Assured-backed bonds were trading at yields more in line with the 'A' category. For some industry observers, this was due to investors who anticipated the Moody downgrade and were already pricing insured bonds at the lower rating level.
We think it may be more like Moody catching up with the markets. Investors didn't wait for the downgrade to start looking more closely at underlying ratings and stop relying solely on an insurer's credit quality. It's a fact that following the collapse of the bond insurance sector, which left Assured as the only bond insurer to actively seek new healthcare business, investors lost some faith in insurers and starting paying closer attention to the borrower's own credit risk.
Given that bond insurance seeks to achieve lower yields by pricing bonds based on an insurer's higher credit quality, the more investors look to underlying ratings instead of the insurer's, the less valuable insurance becomes.
While borrowers aren't getting the bang for the buck they used to, as with other forms of credit enhancement, insurance can still make sense for some hospitals under the right circumstances.
How Bond Insurance Works
For hospitals wanting to find out if bond insurance is a viable option, a basic understanding of the product's inner workings is important. As with other credit enhancement products, bond insurance boils down to cost vs. benefit:
- Cost: hospital pays premium based on a percentage of scheduled total debt service.
- Benefit: hospital pays a lower coupon based on the credit enhancer's higher rating.
Insurance becomes attractive when the present value (PV) of the debt service savings is greater than the premium.
Assured premiums average around 65 bps (0.65%) of total debt service, but will vary depending on the borrower's underlying ratings. For a hospital selling 4%, 30-year bonds with level debt service, 65 bps translates into approximately 1% of par amount. For insurance to generate net savings at this premium level, the hospital has to save more than 1% of par in debt service over the life of the bonds (adjusted for PV). The higher the premium, the more PV debt service savings needed for insurance to work.
Here is a practical example. Note that we kept things simple by assuming par bonds (coupon = yield):
A refunding can have a material impact on the value proposition if the policy is not transferable and the unearned premium not credited, as is often the case. In our example, if the hospital were to refund its bonds 10 years out without being able to transfer the policy --or apply the insurance to new bonds but fail to match prior savings-- the PV savings go from $1.2 million to $570,000, less than the premium, making insurance worthless.
For clients considering bond insurance, we will model various refunding scenarios to quantify the impact of expected net savings.
Debt service savings are highly sensitive to the yield differential between unenhanced and insured bonds. In our prior example, an mere 10 bps in yield is worth around $500,000 in PV savings, almost as much as the premium itself. Consequently, minor changes in yield savings can make or break insurance, and it is critical for hospitals evaluating insurance to use realistic yield assumptions.
Yield assumptions can be complex to develop as not two borrowers are the same. This is where a knowledgeable advisor can research comparable credit spreads for the hospital, both insured and uninsured. To reduce uncertainty, the bonds can be pre-qualified for insurance, then the two options (insured and uninsured) dual-tracked until the hospital gets closer to day of pricing, at which point the value proposition can be finalized.
Investors had already priced lower rating levels into Assured fixed-rate bonds, so there wasn't much consequence to the downgrade. Insured variable-rate bonds on the other hand took a small but measurable hit.
Unlike fixed-rate bonds whose coupon is set on the date of pricing, the coupon on variable-rate bonds is reset daily or weekly based on the insurer's perceived credit quality. In the case of Assured, the dozen or so hospitals with an average of $50 million in insured weekly variable-rate bonds experienced a slight increase in their resets since the Moody downgrade (see chart).
All things considered, the Moody downgrade has had relatively little impact on the markets, not only because investors were ahead of Moody, but also because of compressed credit spreads.
Credit spread is the premium over an index (e.g. MMD) that bondholders demand in exchange for taking on a borrower's repayment risk.
Hospital credit spreads compressed significantly in 2012. As a result, the difference between 'AA' and 'A' category spreads has narrowed, which dampened the deteriorating perception of Assured as a credit risk.
But credit spreads are a double-edged sword for Assured since its value proposition depends on elevating a borrower's credit quality. Because of credit spread compression, the value of jumping from a 'BBB' category yield to the 'A' category yield, where Assured trades, has diminished.
To make up for reduced savings, Assured can adjust its premiums, but only up to a point. Premiums are negotiated based on the borrower's credit quality, and usually set so that debt service savings are split 50/50 with the borrower. Assured's ability to make the math work is limited since as we've seen, it takes a lot of premium to make up for a small change in yield savings.
There are other factors that hospitals looking at bond insurance ought to consider.
Traditionally, Assured and other bond insurers have required more onerous terms than most public bondholders. These terms can restrict a hospital’s flexibility to issue new debt, dispose of assets, or add to disclosure requirements, but some can be negotiated.
We've seen a number of hospitals encountering difficulties with getting consent from bond insurers, and in some extreme cases, being refused consent unless the insured bonds are taken out. This isn't the case with Assured, who is actively seeking new business and has a strong incentive to work with borrowers.
What Should Hospitals Do
In spite of the recent downgrade, Assured’s value proposition continues to be attractive for borrowers who reside within the insurer's sweet spot where insurance can squeeze enough debt service savings to cover the premium.
As financial advisors, our recommendation is that prior to issuing fixed-rate tax-exempt bonds in the public markets, hospitals get a preliminary indication on insurance as an option. It may or may not work, the main factor being the hospital's underlying rating. If the rating is too low, the hospital will not qualify. If the rating is too high, insurance will not produce the desired yield savings compared to uninsured bonds. Although every situation is different, the sweet spot is often the 'BBB' category.
There isn't much downside to talking to a bond insurer like Assured to see if under the right combination of underlying rating, market conditions, and deal structure, insurance can create savings.
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