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Summer Educational Event Capital and Finance Market Trends

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1 Summer Educational Event Capital and Finance Market Trends
Presented to: Capital and Finance Market Trends July 29, 2013 Donald J. Persinski Managing Director PNC Capital Markets LLC

2 MSRB G-17 Disclosure PNC Capital Markets (“PNCCM”) is providing the information contained in this document for discussion purposes only in anticipation of serving as an underwriter to the issuer to whom this document is addressed. The information provided herein is not intended to be and should not be construed as “advice” within the meaning of Section 15B of the Securities and Exchange Act of 1934, as amended.. The following disclosures are required by Municipal Securities Rulemaking Board (“MSRB”) Rule G-17, as PNCCM proposes to serve as an underwriter, and not as a financial advisor, municipal advisor or fiduciary to any person or entity, in connection with the issuance and sale of securities for the issuer to whom this is addressed: (i) MSRB Rule G-17 requires an underwriter to deal fairly at all times with both municipal issuers and investors. (ii) An underwriter’s primary role is to purchase securities with a view to distribution in an arm’s-length commercial transaction with an issuer; and an underwriter has financial and other interests that differ from those of such an issuer. (iii) Unlike a municipal advisor, an underwriter does not have a fiduciary duty to an issuer under the federal securities laws and is, therefore, not required by federal law to act in the best interests of that issuer without regard to its own financial or other interests. (iv) An underwriter has a duty to purchase securities from an issuer at a fair and reasonable price, but must balance that duty with its duty to sell those securities to investors at prices that are fair and reasonable. (v) An underwriter will review the official statement, if any, for those securities in accordance with, and as part of, its responsibilities to investors under the federal securities laws, as applied to the facts and circumstances of the transaction.

3 Portfolio Management Investment Portfolio Debt Portfolio
Cash/Money Market Funds Fixed Income – Corporate Fixed Income – US Treasury Equity – US Equity – International Equity – Mutual Funds Alternative Investments Debt Portfolio Fixed Rate Variable Rate Short-Term (working capital line) Long-Term (PP&E) Derivatives Public Debt Bank Loans Strategies Diversification Risks Duration Liquidity 3

4 Sources of Capital Operations – Cash Flow Reserves – Balance Sheet
Philanthropy / Capital Campaign / Grants Asset Monetization – Sale of Non Core Assets (Land, Skilled Nursing Facility, etc.) Partnerships, Joint Ventures, Mergers Capital Markets (Tax-exempt and Taxable Rates) Fixed Rate Bonds Variable Rate Demand Bonds supported by a Letter of Credit Floating Rate Notes Direct Bank Placement Construction Loan Line of Credit (Working Capital or Project Financing) Leases (Capital and Operating) Derivative Products and Strategies 4

5 Decade of Municipal Bond Finance ($000)

6 Municipal Bond Issuance – Year-to Date Comparison (June 30)

7 Municipal Bond Issuance – State Rankings

8 Healthcare Bond Issuance
The volume of Health Care bond issuance has declined in recent years. Factors contributing to this decline include: uncertainty due to healthcare reform; a tightened credit market; fewer refunding opportunities; and significant growth in bank direct placements. Note: data is through June 30. 8

9 Healthcare Bond Issuance: January 1, 2013 – June 30, 2013
Total Par Amount: $195,200,000 St. Luke’s Health System Doylestown Hospital The Washington Hospital Catholic Health East Hanover Hospital 9

10 Recent Fixed Rate Healthcare Bond Issues

11 Segmenting Market Risk

12 Financing Option – Fixed Rate Bonds
Most conservative structuring alternative; Eliminates ongoing interest rate risk Issue with a maturity of up to 40 years; Bonds typically not callable for 10 years Bonds issued based solely on the credit strength of the borrower Security, covenants and disclosure may include all, or most of the following: Revenue pledge, mortgage, debt service reserve fund Tightened liquidity and capital structure covenants – additional ratios have emerged, including variable rate and short term debt ratios/measures Quarterly disclosure Credit rating from multiple agencies Steepening yield curve 1-year yield has not changed Current 30-year yield 164 basis point increase since the low on November 30, 2012 (approximately 8 months) 100+ basis point increase since May 15, 2013 (2 months) 12

13 Current and Historical MMD Rates
AAA MMD 10, 20 and 30-Year Maturity Historical Rates July July 2013 AAA MMD 30-Year Maturity Historical Rates January 7, 2013 to Present Municipal Market Index (MMD) "Municipal Market Data," is a proprietary yield curve for municipal market (tax-exempt) issues published daily by Thomson Financial Services and widely used as a benchmark for determining interest rates on new issue and secondary market tax-exempt issues. In November 2012, the 30-year MMD maturity fell to its historic low of 2.47%. As of July 19, 2013, the 30-year MMD maturity was 4.14%. 13

14 Credit Spreads – Tax-exempt Healthcare Bonds
Municipal Market Data High-Grade Yield Curve Industry standard (Both Buy Side and Sell Side) Represents where high-grade, natural Aaa paper is trading The MMD curve serves as a benchmark for municipal bonds just as Treasury bonds do for corporate bonds 14

15 10YR AAA MMD versus 10YR US Treasury Yields
5/2 MMD: 1.66 UST: % 7/12 MMD: 2.66 UST: % 15

16 Municipal Fund Flows vs 20 year MMD
YTD 2013: $8.5B outflows June 2013: $10.7B outflows 16

17 Variable Rate Demand Bonds Public Floating Rate Notes (FRN)
Variable Rate Alternatives – Key Differentiating Factors Variable Rate Demand Bonds Letter of Credit (LOC) or Standby Bond Purchase Agreement (SBPA) Renewal Risk Basel III Regulatory Risk Bank Purchased Bonds Priced as spread to percent of LIBOR or SIFMA Limited Put Risk Longer Tenor than Letter of Credit Public Floating Rate Notes (FRN) Newest Product Priced as a spread to LIBOR or SIFMA No LOC or SBPA required 17

18 Municipal Bond Issuance
Total municipal issuance peaked in 2010 followed by a sharp decline in 2011. Variable rate issuance has declined following the events of 2008 which heightened awareness of certain risks. 2011 2012 2013 18

19 History of Municipal Variable Rate Bond Issuance

20 Total VRDN Market Size ($000)

21 Financing Option – Variable Rate Bonds with Bank Letter of Credit
Variable Rate Demand Obligation (VRDO) with Direct-Pay Letter of Credit (LOC) Short-term multi-mode interest rate reset (daily, weekly, monthly, etc.) Exposure to interest rate risk Produces lower cost of debt when yield curve is normal (upward sloping) Provides the most flexible redemption options The bonds will be sold on the credit strength of the bank providing the LOC LOC terms can be extended 3 to 5 years with annual renewal provisions Interest rates at historically low levels Successful remarketing each week Bank letters of credit may be challenging to procure Fewer options due to credit deterioration throughout the industry Bank renewal concern Pricing may be tiered to rating and/or financial performance Ancillary business may be required 21

22 SIFMA – Median, Maximum and Minimum Rates (2000 to Present)
SIFMA Index SIFMA – Median, Maximum and Minimum Rates (2000 to Present) 22

23 Liquidity and Letter of Credit Trends
After spiking in early 2009, liquidity and LOC pricing has declined considerably Depending on Credit Profile, Term and Structure LOC pricing at 150+ basis point in early 2009, now as low as 60 – 125 basis points Multi-year commitments now available (1 Year LOCs were common in 2008 and 2009) Incremental business expectations have lessened, but continue Greater variation in remarketing rates based on liquidity or LOC provider Variation has settled somewhat, but market extremely sensitive Fewer acceptable names causing greater concentration Money market eligibility Greater interest in self liquidity issues Exclusion of “Auction Rate Mode” Inclusion of a “Bank Mode” Takes advantage of bank qualification Can include “draw down” provisions Especially beneficial for long construction projects Conversion into public market may require additional work Rating, Disclosure document, Remarketing agreement Inclusion of an “Index Mode” 23

24 Access to Commercial Bank LOC’s
Highly Rated, Relationship Banks = Best Partner/Provider One-off transactions may not prove to be reliable long term (i.e., renewal/extension concerns) Pending Regulations Bank capital reserve requirements Direct Bank Placements may be offered as an alternative Increased Awareness on Covenants and Other Terms/Conditions More restrictive covenants Increased focus on term out provisions, expiration dates (i.e., long-term balance sheet classification) Grid pricing, rating triggers Yield protection language Ancillary Requirements Capacity/Hold Limits 24

25 US Banks’ Municipal Holdings – Cost Basis
As of December 31 1993 to 2012 Increase of $175.3 billion 222.7% increase 2012: 22.3% 2011: 15.7% 2010: 13.7% 25

26 Buys debt from Issuer under Credit Agreement
What is a Direct Bank Placement/Loan? A Direct Bank Loan is a financing structure in which debt is purchased by a financial institution instead of being publicly sold / remarketed in the capital markets Tax-exempt Direct Bank Loan structures have been used with increasing frequency over the past two years due to decreased bank capacity for letters of credit and significant number of expiring letters of credit on variable rate bonds Driven by borrowers’ desire to shed bank trading risk and lock in a fixed spread Issuer / Borrower - Proceeds from bank loan used to finance tender of existing bonds or for new money purposes - Pays a fixed spread over variable index rate for initial purchase period Bank Loan Proceeds Purchaser Buys debt from Issuer under Credit Agreement Holds debt at a variable index rate plus a fixed spread for a specified period 26

27 Direct Bank Loan Structures
Similar to variable rate bonds Direct Bank Loan is treated as another mode Requires a Trust Indenture Allows bonds to be converted to variable rate with letter of credit Requires a Bond Trustee Provides additional flexibility allowing borrower to convert to other modes in the future Bank covenants and terms in separate document (i.e. Bondholder Agreement, Funding Agreement– similar to Reimbursement Agreement) Alternative structure No Trust Indenture Bank covenants typically in Loan Agreement Assumes debt will remain in Direct Bank Loan form 27

28 Bank Loan as an Alternative to a Public Offering
Direct Bank Loans have become an attractive alternative to public offerings of fixed or variable rate bonds Bonds are usually placed with a long-term maturity and can have periodic puts/renewals (e.g., 3, 5 or 7 years) Can be structured as variable or fixed rate (conventionally fixed based on cost of funds or interest rate swap) Variable rate are priced at a spread to LIBOR and adjusted by a tax factor The credit/loan spread is determined by the credit profile of the borrower Tax factor is typically 65-70% Pricing may look like (70% of 1 Month Libor) + credit spread 28

29 Upfront Cost Comparison
Direct Bank Loan Capital Markets Official Statement/Disclosure Requirements NO YES Rating Agency Indenture Tax-Exempt Opinion Underwriter Underwriters’ Counsel Bank Counsel Bond/Tax Counsel 29

30 Direct Bank Loan vs Direct-Pay Letter of Credit
Benefits of a Direct Bank Loan Reduce remarketing risk by moving outstanding debt out of the capital markets and placing directly with the bank Avoid liquidity event caused by a failed remarketing Reduce bank counterparty risk in uncertain environment for bank ratings Interest rate paid is tied to underlying index Rate not affected by changes in bank rating or investor sentiment Reduce exposure to unexpected market shocks causing bonds to be “put back” by investors Possible longer tenor on facility, reducing renewal risk Possibly reduce annual costs by eliminating remarketing and trustee fees Benefits of Direct-Pay Letter of Credit Mature structure with full acceptance in the capital markets Potentially lower up-front costs when switching credit providers due to familiarity of structure and consistency of documentation across transactions. Up-front costs are becoming more comparable More conducive structure for bonds with bullet maturities Direct bank loan may require some level of annual principal amortization Multi-year term-out provisions typical in the event of a failed remarketing Term-out provisions are not typical with Direct Bank Loan structures Full principal is typically due at the end of purchase period if facility is not renewed or replaced 30

31 Floating Rate Notes (“FRNs”)
2012 through 2013 Year to Date Number of Issues Issue Amount Total FRN Market 80 $17.5 Billion Healthcare 13 $1.3 Billion BBB Healthcare 3 $306.0 Million No bank support and no ongoing remarketing Float relative to an index, typically SIFMA, but can be priced as a percentage of LIBOR. The pricing spread is determined at the time of pricing and fixed for the duration of the Floating Rate Note Period The Floating Rate Note Period is typically 1 to 5 years in length, but PNCCM has observed periods as long as 10 to 15 years FRNs can be issued with either a hard put or a soft put. With a hard put structure, upon maturity or the mandatory tender date, outstanding principal is due and failure to pay is an event of default With a soft put structure, upon maturity or the mandatory tender date, failure to pay at the tender date constitutes a “failed remarketing” and can trigger interest rate escalation to a maximum rate and/or accelerated amortization. An FRN with a soft put could also be structured with an interest rate that gradually “steps up” to the max rate instead of directly defaulting to max rate at the time of the failed remarketing FRNs generally are not subject to optional redemption until six months prior to the end of the Floating Rate Note Period. If the FRNs are not retired at maturity or at the end of the Floating Rate Note Period, the FRNs may be remarketed into a new Floating Rate Note Period or refinanced by new FRNs, variable rate demand obligations (VRDBs), fixed rate bonds, or other obligations.

32 Market Overview of FRNs
The market for FRNs has grown significantly since the auction market collapse in Initial issuances involved highly rated issuers, but FRNs are now available as a tool for issuers in a broad range of credit quality The market initially expanded as a result of reduced capacity in the bank market. More recently, the market has grown as long-term municipal investors increase exposure to variable rate products to position for rising rates. FRNs serve as a non-bank alternative to a traditional VRDBs “Linked-rate” volume increased by 17.56% from 2011 to Volume increased 123% in the first quarter of 2013 over 2012, and we expect continued growth in this market

33 FRN Considerations Benefits Considerations
Third-party credit and liquidity support is not required – eliminating bank renewal risk, counter-party risk and ongoing remarketing risk During the Floating Rate Note Period, the bonds can not be tendered by investors Borrowers can select SIFMA, LIBOR, or a % of LIBOR as the underlying index. This may be beneficial if the borrower has existing swaps that they do not wish to terminate and can use as a hedge for an FRN with a matching index FRNs can be issued as part of a multi-modal issue providing flexibility at the end of the Floating Rate Note Period to refinance into a variety of alternate structures (or a subsequent Floating Rate Note Period) Interest rate risk is inherent to this structure and is based on the selected underlying index (SIFMA, LIBOR, or a % of LIBOR) At the mandatory tender date or maturity, the borrower is subject to refinancing risk and potentially higher spreads to the underlying index based on a change in market conditions, changes in tax law, or the borrower’s credit profile If structured with a “hard put” the borrower may be required to fund the entire purchase price of the FRNs. If structured with a “soft put” the interest rate could escalate to the maximum interest rate and/or accelerated principal payments (if remarketing is unsuccessful) Optionality within the structure is achievable but the extent of optionality will be less than what is embedded within a typical VRDB solution Term on both put structures is getting longer, but price discovery is critical in this phase of the market’s development

34 FRNs- Hard Put vs Soft Put
A hard put can be incorporated in a structure with a mandatory tender or maturity. Both structures typically incorporate a call date 6 months prior to the principal payment date An event of default occurs if the FRN is not funded on the date of the mandatory tender or maturity The primary concern for investors is the ability of the borrower to access the market at the mandatory tender date Soft Put A soft put is typically structured as part of a term mode remarketing of multi-modal bonds, often with a call date 6 months prior to the soft put date In soft put structures, investors will also focus on refinancing risks and the maximum rate in the case of a failed remarketing Soft puts can be structured with a step coupon, where at the time of failed remarketing the interest rate gradually steps up to increasingly penalizing rates until it reaches the max rate

35 Capital Structure Consideration
Floating Rate Note Public Offering This slide can be modified and pricing can be entered by double clicking on the image.

36 Sources of Capital – Summary of Costs and Risks

37 Capital Structure & Bank Renewal Consideration
This slide can be modified and pricing can be entered by double clicking on the image.

38 Capital Structure & Interest Rate Risk Consideration
Composition of Underlying Debt This slide can be modified and pricing can be entered by double clicking on the image. Interest Rate Exposure

39 Standard Disclosure PNC Capital Markets LLC ("PNCCM"), member FINRA and SIPC, is a wholly owned subsidiary of The PNC Financial Services Group, Inc. PNCCM is an affiliate of PNC Bank, National Association; however, it is not a bank or a thrift and is a separate and distinct corporate entity from its bank affiliate. This document is for informational purposes only. No part of this document may be reproduced in any manner without the prior written permission of PNCCM. Under no circumstances should it be used or considered as an offer to sell or a solicitation of an offer to buy any of the securities or other instruments mentioned in it. The information contained herein is based on information PNCCM believes to be reliable and accurate, however, no representation is being made that this document is accurate or complete and it should not be relied upon as such. Neither PNCCM nor its affiliates make any guaranty or warranty as to the accuracy or completeness of the data set forth herein. Opinions expressed herein are subject to change without notice. The securities or other instruments mentioned in this document may not be eligible for sale in some states or countries, nor suitable for all types of investors; and their value and the income they produce may fluctuate and/or be adversely affected by changes in exchange rates or interest rates or other factors. PNCCM and/or its affiliated companies may make a market or deal as principal in the securities mentioned in this document or in options or other derivative instruments based thereon. In addition, PNCCM and its affiliated companies, shareholders, directors, officers and/or other employees may from time to time have long or short positions in such securities or in options, futures or other derivative instruments based thereon. One or more directors, officers and/or employees of PNCCM or its affiliated companies may be a director of an issuer of securities mentioned in this document. PNCCM or its predecessors and/or affiliates may have managed or co-managed a public offering of or acted as initial purchaser or placement agent for a private placement of any of the securities for any issuer mentioned herein within the last three years, or may from time to time perform investment banking or other services for or solicit investment banking or other business from any company or issuer mentioned in this document. PNC Capital Markets is the marketing name used for investment banking and capital markets activities conducted by The PNC Financial Services Group, Inc. through its subsidiaries PNC Bank, National Association and PNC Capital Markets LLC. Services such as public finance advisory services, securities underwriting, and securities sales and trading are provided by PNC Capital Markets LLC. Foreign exchange and derivative products are obligations of PNC Bank, National Association 39


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