- Tax-exempt bonds pay interest based on prevailing interest rates plus a credit spread.
- Credit spreads vary based on credit quality and the underwriter's performance in pricing and distributing the bonds.
- The traditional approach to compare credit spreads based on the longest maturity does not always reflect the true cost of credit.
- The new formula makes pricing evaluation more accurate by capturing the spread on all maturities, not just the long bond.
The municipal bond markets have often been criticized for their lack of transparency, and for many borrowers, bond pricing remains a mystery. To better understand pricing, hospitals need to understand credit spreads.
Credit spread is the premium over a high quality index (most commonly, the “AAA” Municipal Market Data benchmark rate) that investors demand in return for taking on a borrower’s repayment risk.
Credit spreads vary directly based on a borrower's credit quality, but not so much on rates -- at least not in the short run-- so two bonds in the same credit category that priced on different days will pay different yields, but their credit spreads ought to be close.
Being relatively impervious to changes in rates, credit spreads are handy because a hospital can use them to directly compare how well its bonds priced against other hospitals in the same rating category.
Because credit spreads eliminate the variability due to changes in interest rates, they are often used to evaluate underwriter performance. Underwriters are expected by borrowers to sell bonds at the lowest possible yields, but they have to serve investors as well (for more on this, read MSRB: Bond Underwriter Can Be BFF, But Not FA). It's a zero-sum game between the two and depending on who gets the better end of the deal, the resulting credit spread can be unfavorable to the hospital.
Some bond underwriters go to great lengths to make a direct comparison of credit spreads difficult for borrowers, mentioning state of issuance, tax preference, terms, butterflies flapping wings in China, etc. The fact is that while there are other factors that impact credit spreads, credit quality and underwriter performance are the most significant.
Measuring Credit Spread
Credit spreads can be used by hospitals to determine if a bond issue priced in line with other similarly-rated offerings, or if underwriter performance was sub-par, but in order to be compared, credit spreads must first be measured.
Traditionally, underwriters use the spread for a bond issue's longest maturity (the so-called long bond) as proxy; other maturities are ignored. This presents a problem because different maturities sell at different credit spreads, so the long bond may not reflect the issue’s total credit spread if all maturities were taken into account.
To be meaningful, credit spread should be measured for all maturities within a bond issue, not just the long bond.
In order to come up with a more accurate measure of credit spread, HFA Partners developed a formula which calculates the issue's total credit spread by taking into account each and every maturity. The formula adjusts each credit spread for the maturity's par amount. The issue's total spread is the internal rate of return on the resulting cash flows.
This approach is similar to calculating a bond issue's overall yield, using credit spreads instead of yields.
HFA Partners compared the total issue spread to the long bond spread for over 650 tax-exempt, fixed rate hospital revenue bond public offerings. In more than a third of bond issues, the long bond spread was off by 10 basis points or more from the total issue spread, with some offerings off by as much as 80 basis points (0.8%).
By taking into account all maturities, the total issue spread approach provides a more accurate picture of the issue's true cost of credit. It also permits a direct comparison between bond issues regardless of amortization structure, so long as the issues are of similar credit quality.
HFA Partners will be reporting total issue spreads (TruSpread) based on the new formula starting with the September 2013 issue of the Hospital Finance Update. All spreads will be based on a calculation of cash flows to maturity, rather than to first call date, regardless of convention. This is a more conservative approach than using the call date convention for premium bonds. For more on this topic, read The Hidden Cost of Premium Bonds.
The calculation will also be offered as a service for hospitals looking to benchmark their cost of debt against peers, or interested in better evaluating underwriter performance or various debt structures.
This material is intended for general information purposes only and does not constitute legal advice. For legal issues, readers should consult legal counsel. To discuss this article or municipal advisory services, email or call 888-699-4830. HFA Partners, LLC is an Independent Registered Municipal Advisor registered with the Securities and Exchange Commission (SEC) and the Municipal Securities Rulemaking Board (MSRB) under the Dodd-Frank Act of 2010.
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