Best Practices Q&A:
Steven J. Backus & Wendy Stojadinovic, Cleary Gull Advisors, Inc.
Steven J. Backus, Client Advisor-Health Care, and Wendy Stojadinovic, Director of Fixed Income, at Cleary Gull Advisors, Inc. in Milwaukee, Wisconsin, talk about investing bond proceeds, the importance of having an investment strategy for those funds, and the best investment options currently available to borrowers.
• Are the credit markets beginning to loosen up? Rates have gone up on the borrowing side, so lenders are willing to lend at those higher rates; the private loan market is really starting to do well. Banks aren’t willing to take on as much risk as before on the not-for-profit side, and some of the big players dropped out of that market entirely. We are seeing more deals coming through, but demand is lower than three or four years ago. Most of the activity involves refinancing by organizations that started a new project two or three years ago with a good portion of the financing in variable-rate debt and now want to lock in a fixed rate in the inevitable event that rates go up. On the investing side, however, rates are still extremely low.
• What advice do you have for those with bond proceeds to invest? In order of importance, key goals to keep in mind when investing bond proceeds are preservation of principal, liquidity, and possible earnings. Generally, bond proceeds that organizations have to invest fall into two buckets:
1) A project fund or a construction fund that will be drawn down, perhaps monthly, over one, two, or three years are very short-term investments, and it’s a little challenging to find a six-month or yearlong maturity that will provide much of a return. You don’t want to be tempted to buy something with a higher yield that you’ll have to sell in six months because you need that liquidity.
2) Debt-service reserves, which don’t have a true end date and are easier to invest, generally sit for the life of the bond issuance, so you can afford to go out a bit further on the yield curve. On the other hand, the value of debt-service reserves is generally reviewed on a quarterly or annual basis. If the account falls below the required amount, the organization would have to deposit its own funds to increase the balance.
• What investment strategy do you recommend to your not-for-profit senior living clients? First of all, we think they should certainly have an investment strategy. Organizations are always bound by the language of the loan agreement or bond indenture, which will have some restrictions on the use of those assets or a stated group of permitted investments. Many times, that language is simply brought forward from an old financing, so it may be out of date as far as which options provide an opportunity for the organization. We recommend a review of that language as they’re going through the financing by someone who is experienced in those types of investments and can evaluate whether it is appropriate for the current times.
Then, because financing is such a huge undertaking for an organization, the board often doesn’t even think about what to do with the bond proceeds once they’ve gone through the financing process. Trustees are usually only obligated to put the proceeds into some sort of vehicle that is allowed in the indenture as a permitted investment. That has often been a money market fund—which was fine when the return was two or three percent. Today, with money market rates basically at zero, they want some alternatives.
Our firm focuses on buying individual securities, which is a more actively managed investment strategy than simply buying a few CDs or locking in a rate with a structured product. We see an opportunity in today’s market to get some yield now but, when rates eventually do rise, to be in a position to turn over the portfolio and take advantage of the higher return. The caveat, of course, is to make sure that the portfolio value doesn’t fluctuate to a point where you break any of the requirements of the loan agreement or indenture. The yield curve for very short maturities, which applies to most of these bond proceeds, is currently steep, so there’s a temptation to push out that yield curve to capture extra yield. That can be a great strategy, as long as you keep in mind when you’ll need to access the funds.
With an active portfolio, it’s also very important to stress test for changes in interest rates over the time period that the money will be invested to ensure that the minimum amount of money required to meet your withdrawals or your debt-service requirement is available. How will that investment or portfolio react when rates rise by one or two percent? Is that value going to drop? And will the organization have to refund the account with its own funds to bring it back up to the required balance? You can’t take the same approach for all proceeds. They’ll differ, depending on the ultimate use and the type of account.
• With the return so low relative to interest rates, are borrowers borrowing more money? They are—or they’re scaling back the project. Back in 2007, for example, a startup CCRC built in an estimated return of 4% to 5% for the various portfolios in its project fund—a return that allowed them to borrow less. Today, with rates as low as zero on the short end, that same startup CCRC would definitely not add in any assumption for growth of the portfolio. Any earnings would simply provide a bit of a buffer to cover increased costs or unbudgeted expenditures.
On the debt-service reserve side, the trustee will periodically withdraw any excess earnings and allow the organization to use that for principal or interest payments. Less money would come out of the organization’s pocket and, ultimately, offset its cost of capital or cost of debt.
• What investment options are available to borrowers? Many options are still viable. Some organizations are comfortable letting the money sit in a money market fund, because they know the money will be there and that it’s not going to fluctuate. Other organizations want some sort of return. We rarely see certificates of deposit being used due to the limitations on liquidity and insurance. There are penalties for pulling out the money before the maturity date—and CD rates for very short periods are relatively dismal. Then, FDIC insurance at most banks covers accounts up to $250,000. If a larger issuance is in a single CD account, a good portion will be above that insured limit. Whether a money market fund is restricted by FDIC insurance depends on the type of money market. Most are treated the same as a mutual fund, as opposed to a bank account, so FDIC insurance would not apply.
Structured products are similar to the swaps that caused trouble for Lehman Bros. and other issuers. Most banks have scaled back on the type of structured products that they offer, especially in the not-for-profit senior living and hospital arenas. So the availability is minimal.
Individual securities can be actively managed so that, as rates rise, the organization can take advantage of new opportunities. And if you’re pretty clear on your flow dates, individual securities allow more flexibility. You can buy an issue for a specific flow date that is less liquid, for example, and earn a greater yield.
Whichever option(s) they choose, taking an active approach can help organizations position themselves for longer term growth. Even if what they’re doing has gotten them through the rough patch, it’s not too late to reassess to see if something else might make better sense going forward with regard to where they want to grow.
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