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, 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 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 at an average interest rate of approximately 5.7 percent.

At the same time we entered into a swap agreement with the Counterparty (JPMorgan Chase Bank) to receive a fixed interest payment of 5.47 percent and pay the current weekly Bond Market Association (BMA) 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 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, CFO 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.

Our organization's relationship with JP Morgan 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 rates (see Figure 1) that compares the Revenue Bond Index (RBI) 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 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 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 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 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 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 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 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 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 Debt Policy

Original: February 2004

Responsible Vice President Corporate Services,

Person: CFO

Approving CentraCare Health System and

Committees: St. Cloud Hospital 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 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. 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 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 fees, covenant requirements, credit enhancement 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.

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, CPE, FACPE

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 [e-mail]. Thanks also to Gerry Means and Andrea Brasel for help with this article.

[ILLUSTRATION OMITTED]