Why develop a debt policy? Consider the risks and rewards of variable rate interest and options for financing debt.Access to capital is a key issue for many organizations and developing a debt policy will help clarify your organization's options for debt financing Debt Financing When a firm raises money for working capital or capital expenditures by selling bonds, bills, or notes to individual and/or institutional investors. In return for lending the money, the individuals or institutions become creditors and receive a promise to repay , evaluate your tolerance for risk of interest rate changes and engage your board of directors with ownership and understanding of the policy. Developing a policy to guide decisions also helps focus the plan on a long-range perspective of interest rates that can help guide appropriate decisions regardless of the short-term Short-term Any investments with a maturity of one year or less. short-term 1. Of or relating to a gain or loss on the value of an asset that has been held less than a specified period of time. outlook. Our organization has about $252 million of long-range debt. This includes $168 million in variable rate debt through a synthetic swap agreement with a major financial institution. Our organization issued fixed rate, 30-year, tax-exempt bonds Tax-exempt bond A bond usually issued by municipal, county, or state governments whose interest payments are not subject to federal and, in some cases, state and local income tax. tax-exempt bond See municipal bond. at an average interest rate of approximately 5.7 percent. At the same time we entered into a swap agreement with the Counterparty Counterparty The other participant, including intermediaries, in a swap or contract. (JPMorgan Chase JPMorgan Chase (NYSE: JPM TYO: 8634 ) is one of the oldest financial services firms in the world. The company, headquartered in New York City, is one of the leaders in investment banking, financial services, asset and wealth management and private equity. With assets of $1. Bank) to receive a fixed interest payment of 5.47 percent and pay the current weekly Bond Market Association (BMA BMA British Medical Association. ) Index. In order to receive a higher fixed interest payment on the swap, we also sold an option to cancel the swap at the first call date on the bonds. The remaining debt of $84 million is in fixed rate bonds with a range of 5 to 5.5 percent interest rates. The opportunity to call in some of our fixed rate bonds and refinance Refinance 1. When a business or person revises their payment schedule for repaying debt. 2. Replacing an older loan with a new loan offering better terms. Notes: When a business refinances they typically extend the maturity date. them at either lower fixed rates or to convert this debt to variable rate options caused us to carefully evaluate our tolerance for interest rate risk and to develop our organization's debt policy. Developing a debt policy requires a team approach, including understanding and support by the CEO (1) (Chief Executive Officer) The highest individual in command of an organization. Typically the president of the company, the CEO reports to the Chairman of the Board. , CFO See Chief Financial Officer. and other key leaders as well as the organization's finance committee and the full board of directors. Networking with colleagues in health care is also helpful to assure the board that you are developing a policy consistent within reasonable guidelines guidelines, n.pl a set of standards, criteria, or specifications to be used or followed in the performance of certain tasks. . Our organization's relationship with JP Morgan Morgan, American family of financiers and philanthropists. Junius Spencer Morgan, 1813–90, b. West Springfield, Mass., prospered at investment banking. as the firm responsible for structuring our swap of the fixed rate bonds to a variable rate of interest made them a trusted resource in developing our policy. One of the key factors in developing our policy was the comparison of fixed and floating tax exempt long-term Long-term Three or more years. In the context of accounting, more than 1 year. long-term 1. Of or relating to a gain or loss in the value of a security that has been held over a specific length of time. Compare short-term. rates (see Figure 1) that compares the Revenue Bond Index (RBI RBI abbr. Baseball runs batted in Noun 1. rbi - a run that is the result of the batter's performance; "he had more than 100 rbi last season" run batted in ) as a benchmark for long-term bonds and the Bond Market Association (BMA) Index which is a benchmark for tax exempt variable rate and the Rolling BMA which is the average of each weekly BMA and represents the average rate paid on tax exempt floating rate debt. Of interest, the current spread between short-term and long-term debt Long-Term Debt Loans and financial obligations lasting over one year. Notes: For example debts obligations such as bonds and notes which have maturities greater than one year would be considered long-term debt. is approximately 4.36 percent and the average spread over the past 15 years is 2.74 percent. The long-range spread between variable and fixed rate debt of 2.74 percent was a significant factor in our organization's comfort level with a plan to continue with a ratio of 70 percent variable rate debt and 30 percent fixed rate debt. [FIGURE 1 OMITTED] Data from numerous other health care organizations was also considered, particularly fiscal, year-end 2002 financial statements that included information on credit rating, long-term debt total, ratio of fixed to floating rate interest, debt to capitalization capitalization n. 1) the act of counting anticipated earnings and expenses as capital assets (property, equipment, fixtures) for accounting purposes. 2) the amount of anticipated net earnings which hypothetically can be used for conversion into capital assets. ratio, days cash on hand and their total of cash and investments. Figure 2 shows the variation from 100 percent fixed rate debt for two institutions to 100 percent floating rate debt for one institution with a substantial amount of variation among other entities. Note that the Mayo Foundation had a ratio of 62 percent floating to 38 percent fixed and the Cleveland Clinic Cleveland Clinic (formally known as the Cleveland Clinic Foundation) is a multispecialty academic medical center located in Cleveland, Ohio, USA. Cleveland Clinic was established in 1921 by four physicians for the purpose of providing patient care, research, and medical had a ratio of 70 percent floating to 30 percent fixed at the time of this report. The current options for long-term debt financing include the following: * Fixed rate tax exempt bonds with an estimated interest rate of 4.69 percent * Fixed rate with a swap to variable rates estimated at BMA (currently 1.03 percent) plus 24 basis points, the difference between the fixed rate on the bonds and the swap receiver rate * Variable rate bonds with a current estimated interest rate of 1.03 percent * A total return swap Total Return Swap Any swap in which the non-floating rate side is based on the total return of an equity or fixed income instrument with a life longer than the swap. Notes: Total return swaps are most common in equity or physical commodity markets. to in essence convert our current fixed rate bonds to a variable rate of BMA plus 15 basis points Developing a debt policy can help the organization balance the financing risk with other risk including the investment balance of its reserve funds. Organizations with a higher risk strategy for investment of its reserves may want a more conservative debt risk. Organizations that pursue more variable interest rate debt may be able to increase their operating income Operating Income The profit realized from a business' own operations. Notes: This would not include income from things such as investments in other firms. Also referred to as operating profit or recurring profit. by interest expense reduction or achieve equivalent total income with a more conservative investment of their reserves. The greatest risk of variable rate debt is the development of economic conditions that drive the variable rate interest to a level that significantly exceeds the long-term fixed interest rate. This can occur in economic conditions with high rates of inflation as occurred in the early 1980s, but which has not been a significant factor in the past 15 years. Organizations with a significant amount of variable rate debt may wish to limit the variable rate debt to an amount equal to their reserve funds so that the variable rate debt could be paid off if circumstances CIRCUMSTANCES, evidence. The particulars which accompany a fact. 2. The facts proved are either possible or impossible, ordinary and probable, or extraordinary and improbable, recent or ancient; they may have happened near us, or afar off; they are public or required it. The value of going through the process of developing a debt policy includes creating a long range strategy that focuses on the long range interest rates, creates understanding and buy-in by the board of directors and is helpful to explain the organization's debt structure to management and employees. Due to a significant spread between the variable and the fixed interest rate performance for the past 15 years, organizations that have not used any level of variable rate interest have foregone fore·gone v. Past participle of forego1. adj. Having gone before; previous. Usage Note: The word foregone has recently developed a new meaning as a truncation of the phrase a significant source of additional income. Whether that added income is worth the risk is up to your administration and your board of directors since past performance is no guarantee of the future. AICPA AICPA See American Institute of Certified Public Accountants (AICPA). Reporting Rules for variable rate financing through a swap arrangement results in financial statement reporting of the financial value of the swap instrument and the debt that is covered by the swap. The reporting requirements for this and the potential impact this can have on the organization's statement of earnings as the swap and debt values fluctuate can significantly affect both the balance sheet and income statement of the organization. It is important that the board of directors fully understands this component of the swap or swap agreement.
Figure 2 Peer group financial indicators (1)
FYE State Hospital/System
1 09/30/2002 IL Evanston Northwestern
2 12/31/2002 UT Intermountain Health Services (Obl. Group)
3 12/31/2002 MN Mayo Foundation
4 12/31/2002 TX Methodist Houston
5 08/31/2002 IL Northwestern Memorial
6 12/31/2002 MO St. Luke's
7 06/30/2002 MO St. Anthony's
8 12/31/2002 MO SSM Health Care
9 06/30/2002 MO Sisters of Mercy Health
10 06/30/2002 CA University of California, LA
11 06/30/2002 CA University of California, SF
12 06/30/2002 MI University of Michigan Hospitals
13 06/30/2002 NC Duke University Health System
14 06/30/2002 MD Johns Hopkins Health System
15 12/31/2002 OH Catholic Healthcare Partners
16 12/31/2002 OH Cleveland Clinic
17 12/31/2002 WA Providence Health System
18 06/30/2002 NY New York City Health
19 12/31/2002 CA Sutter Health Affiliates
20 09/30/2002 MA Partners Healthcare
21 06/30/2002 CA Catholic Healthcare West
22 06/30/2002 MI Trinity Health Corporation
23 06/30/2002 CO Catholic Health Initiatives
24 06/30/2002 MO Ascension Health
25 12/31/2002 IL Kaiser Foundation Hospitals
26 12/31/2002 MO BJC HealthCare
27 12/31/2002 CO Poudre Valley Health System
28 06/30/2002 MN CentraCare Health System
Credit Cash & Debt Mix Swap
Rating LTD Investments Fixed Floating Participant
(Moody's/S & P) ($mm) ($mm) (%) (%) (Y/N)
1 Aa2/AA+ 627.3 1,043.2 20% 80% Y
2 Aa2/AA+ 812.8 990.6 70% 30%
3 Aa2/AA 1,446.7 1,574.9 38% 62%
4 NR/AA 950.0 1,574.9 0% 100%
5 Aa2/AA+ 377.9 684.8 51% 49% Y
6 NR/AA- 189.4 362.6 58% 42% Y
7 A2/A 83.6 173.3 100% 0%
8 NA/AA- 935.2 902.8 79% 21%
9 Aa1/AA 530.7 1,062.0 32% 68% Y
10 Aa2/AA- 152.8 12.9 100% 0%
11 A2/A 166.7 50.3 65% 35%
12 Aa2/AA 310.7 785.2 51% 49% Y
13 Aa3/AA 496.3 610.3 82% 18% Y
14 A1/AA- 590.6 221.5 85% 15%
15 A1/AA- 1,352.8 1,193.3 86% 14% Y
16 A1/A 1,050.4 711.9 30% 70% Y
17 Aa3/AA- 740.3 881.3 54% 46%
18 A3/BBB 769.7 400.8 53% 47%
19 A1/AA- 1,271.0 1,385.0 54% 46% Y
20 Aa3/AA- 1,075.3 1,960.0 83% 17% Y
21 Baa1/BBB 2,140.2 1,289.1 77% 23% Y
22 Aa3/AA- 1,539.4 1,892.9 83% 17% Y
23 Aa2/AA 1,955.2 2,354.6 66% 34% Y
24 Aa2/AA 2,382.1 3,108.4 47% 53%
25 A3/A 2,251.0 7,074.0 77% 23% Y
26 Aa2/AA 491.5 871.8 91% 9%
27 A3/A- 104.7 140.3 61% 39% Y
28 A2/A- 263.4 155.7 37% 63% Y
Debt-to- Days cash-
Cap on-hand
(%) (days)
1 40.8% 447.5
2 41.5% 210.5
3 48.2% 141.8
4 38.7% 597.7
5 23.9% 358.2
6 32.6% 261.5
7 24.6% 223.0
8 46.9% 207.5
9 22.8% 176.9
10 79.3% 6.1
11 81.8% 23.0
12 25.5% 328.5
13 39.4% 184.3
14 54.4% 59.1
15 52.1% 174.4
16 57.5% 91.8
17 30.0% 99.2
18 68.8% 36.6
19 44.9% 114.8
20 35.1% 183.1
21 57.2% 109.8
22 37.7% 158.7
23 37.2% 161.8
24 40.3% 159.5
25 26.6% 119.9
26 22.9% 154.5
27 43.8% 262.4
28 56.4% 157.9
(1) Source: FYE 2002 financial statements
RELATED ARTICLE: Sample Debt Policy CentraCare Health System The CentraCare Health System is a system of health care providers in Central Minnesota, United States. It comprises three hospitals, four long-term care facilities, nearly a dozen clinics and numerous specialty care services. Debt Policy Original: February 2004 Responsible Vice President Corporate Services Activities that combine or consolidate certain enterprise-wide needed support services, provided based on specialized knowledge, best practices, and technology to serve internal (and sometimes external) customers and business partners. , Person: CFO Approving CentraCare Health System and Committees: St. Cloud Hospital St. Cloud Hospital is a hospital in St. Cloud, Minnesota, United States. It is a Catholic-affiliated, not-for-profit institution and part of the CentraCare Health System. The hospital has over 3,850 employees, 375 physicians and 865 volunteers. Finance Committees Category: Finance Policy The CentraCare Health System will finance the growth and development of the corporation with corporate earnings and debt. Any debt placed on the corporation must be understood and approved by the board of directors. Purpose The purpose of this debt policy is to set standards for incurring in·cur tr.v. in·curred, in·cur·ring, in·curs 1. To acquire or come into (something usually undesirable); sustain: incurred substantial losses during the stock market crash. 2. debt that the corporation will use to further its mission of being the provider of choice for quality health care services to the residents of Central Minnesota Central Minnesota is the name of the region consisting of the central portion of the state of Minnesota. Although no specific boundaries of the region exist, most definitions of what makes up the region would generally consist of the vast swath of land north of Interstate 94, east . This policy is to be reviewed annually and adopted by the Finance Committee of CentraCare Health System and St. Cloud Hospital. Description of Debt The corporation will access debt that is effective and efficient in meeting and furthering its corporate purposes. Responsibilities--Finance Committees: The CentraCare Health System and St. Cloud Hospital Finance Committees will act prudently and in the best interest of the corporations they represent. GUIDELINES 1. The corporation will diversify diversify To acquire a variety of assets that do not tend to change in value at the same time. To diversify a securities portfolio is to purchase different types of securities in different companies in unrelated industries. its debt to its best advantage to reduce its true and full cost of debt. 2. Cash flow and annual debt service will be a consideration in the debt structure. The leverage the corporation will carry will be reviewed in terms of the relationship of its long-term debt to its long-term investments. 3. Reporting of the cost of debt will include the amortization of all associated debt issuance costs and fees. 4. Debt covenants must be understood and agreed to by the Finance Committees. An annual report of the corporation's compliance status with all significant debt instrument covenants, including debt service coverage, will be made to the finance committees. 5. An annual report will be presented to the Finance Committees relative to the Moody's Investor Services credit rating of the corporation. 6. The corporation may use an outside, independent consultant for the issuance of significant debt or the re-structuring of its debt. The purpose of the consultant is to avail the corporation of a national perspective on underwriter underwriter n. a company or person which/who underwrites an insurance policy, issue of corporate securities, business, or project. (See: underwrite) UNDERWRITER, insurances. One who signs a policy of insurance, by which he becomes an insurer. fees, covenant requirements, credit enhancement Credit Enhancement A method whereby a company attempts to improve its debt or credit worthiness. Notes: Credit enhancements take many different forms. An example of a credit enhancement would be conversion rights added on to a debt instrument in order to lower the issuing requirements, an opinion of market interest rates independent of the underwriter and alternative debt instruments. 7. The corporation will utilize available debt vehicles including standard, traditional bonds and derivatives derivatives In finance, contracts whose value is derived from another asset, which can include stocks, bonds, currencies, interest rates, commodities, and related indexes. Purchasers of derivatives are essentially wagering on the future performance of that asset. . 8. The corporation will generally issue debt for projects to be financed for a term to coincide with the useful life of the asset that is financed with the debt. 9. The corporation will generally utilize a mix of fixed and variable rate long-term debt. The current target mix will be 30% fixed-rate debt and 70% variable-rate debt unless the then current conditions indicate a different debt mix is appropriate. The industry norm for fixed and variable rate debt mix is a factor in the mix at any given time. Reports from the rating agencies and bond underwriters will be utilized to determine this mix. 10. The corporation is tax-exempt and will generally, but is not required to, issue tax-exempt debt. 11. The corporation will target its investment portfolio to be equal to the total of its long-term debt. 12. The corporation will avoid, to the best of its ability, any mortgages on its property and debt service reserve funds. This objective will be market dependent at the time of debt issuance. 13. The corporation has established a long range target of having its long-term investments and debt service reserve funds equal to or greater than its long term debt. By Terence Pladson, MD, MBA MBA abbr. Master of Business Administration Noun 1. MBA - a master's degree in business Master in Business, Master in Business Administration , CPE (Customer Premises Equipment) Communications equipment that resides on the customer's premises. CPE - Customer Premises Equipment , FACPE FACPE Fellow of the American College of Physician Executives Terence Pladson, MD, MBA, CPE, FACPE, is president of CentraCare Health System in St. Cloud, Minn. He can be reached at 320-240-2157 or pladsont@centracare.com. Thanks also to Gerry Means and Andrea Brasel for help with this article. [ILLUSTRATION OMITTED] |
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