While expanded health care coverage under the Patient Protection and Affordable Care Act (ACA), commonly known as Obamacare, brings the prospect of accelerated volume growth, Pimco believes this tailwind is unlikely to materially impact results for not-for-profit hospitals in 2014. So far, enrollment gains from the newly opened health care exchanges remain sluggish, and the initial penalties for not participating have provided little financial incentive for people to enroll.
Despite these operating challenges, however, not-for-profit health care providers have fortified their balance sheets in recent years against future margin deterioration, and as a result, Pimco believes that high-quality, not-for-profit hospitals should continue to be a source of low-risk additional yield potential — or what we call “safe spread.”
The not-for-profit health care sector has been a critical source of yield in the municipal bond universe. Since 2004 bonds issued for acute care hospitals, outpatient centers and various other acute and postacute capacities have averaged 10.2 percent of total primary market municipal volumes, according to data compiled by The Bond Buyer, a daily newspaper covering municipal bonds. Our analysis indicates that 30-year hospital debt rated double-A by Moody’s Investors Service and Standard & Poor’s has provided 60 basis points to 100 basis points of additional yield versus triple-A-rated general municipal obligations.
When the financial crisis began in 2008, the health care sector came under pressure to contain costs because of lower patient volumes and revenues as people delayed or simply avoided the expense of care. Every year since, Moody’s has maintained a negative credit outlook on the not-for-profit health care sector and reiterated that view in late November for the year ahead. Although we concur with much of the supporting evidence, we disagree with Moody’s outlook.
The ACA may mean slower revenue growth for acute care hospitals, in part because of changes in Medicare aimed at reducing costs. For the present year, Medicare, which accounts for more than 40 percent of an average hospital’s gross revenues, is expected to grow by only about 1 percent (versus 3 percent to 4 percent historically); and under the ACA, more Medicare cost control measures will take effect over the next several years. Moreover, while adjusted discharge growth, a measure of patient volumes, will likely be flat to slightly positive depending on the market, the ongoing secular shift to outpatient care has a dilutive effect on hospital revenues.
In addition, the quality of care mandates of health care reform will likely increase expenses, contributing to margin moderation in this fiscal year. Under the ACA, Medicare will penalize hospitals that report below-median performance relative to certain criteria, including readmission rates and hospital-acquired infections. Consequently, not-for-profit hospitals have moved aggressively to employ their medical staffs directly and to implement electronic health records. Whereas both of these initiatives are intended to more closely align care protocols and improve quality of care, the cyclical impact is higher expense burdens on hospital providers.
Although we anticipate continued margin moderation in 2014, many not-for-profit hospital balance sheets have improved to prerecession levels. We believe this improved fiscal health will help the sector, especially high-quality providers, absorb the impact of lower margins.
For fiscal year 2012, both double-A- and single-A-rated hospitals showed unrestricted liquidity in excess of direct debt obligations, according to median financial data from Merritt Research Services, a Hiawatha, Iowa–based municipal bond credit information company. Pimco’s analysis indicates that this trend can be directly attributed to improved investment returns and lower capital spending rates. Additionally, in contrast to their general municipal counterparts, most hospital providers have actively contributed to their defined benefit pension plans and utilized more appropriate discount rates to value their pension liabilities. As a result, according to Merritt Research data, unfunded pension liabilities account for only a 10 percent increase in hospital debt levels as of December 31, 2012.
Pimco does not anticipate that hospital capital spending will increase to pre-2008 levels during the next six to 12 months. We have found that, owing to the ongoing shift to outpatient care, hospitals in general are not facing the capacity constraints they did earlier in the decade. According to Moody’s, inpatient occupancy rates have declined from 69 percent in 2008 to the present 64.4 percent. While many hospitals are directing funds to additional ambulatory, or outpatient, care, such a strategy is a significantly less capital-intensive undertaking.
In our view, margin moderation and ongoing balance sheet deleveraging will create an increasingly bifurcated investment universe in the not-for-profit health care sector. During the next three years, we expect that double-A- and strong single-A-rated providers will continue to report unrestricted liquidity in excess of direct debt. Small providers and safety net facilities, which are more directly levered to the favorable execution of federal reform, however, will likely struggle to adopt the ACA’s strategic mandates, resulting in disproportionate margin declines. Over the past five years, single-site, triple-B-rated facilities generally have been supported by an M&A binge. But over the secular horizon, Pimco believes, this trend makes for an increasingly difficult investment thesis, as declining inpatient use rates create the potential for excess capacity.
We believe the incremental yield potential offered by high-quality health care providers represents relatively “safe spread” in light of their recent deleveraging. Moreover, we believe that the pledged security and covenants on not-for-profit hospital obligations typically offer additional protection, compared with investment-grade corporate bonds. For example, most double-A- and single-A-rated health care issuers provide a lien on their revenues. In some instances these issuers may further grant a first mortgage on their land and improvements. Finally, most investment-grade hospital issuers also promise through bond covenants to maintain defined levels of coverage relative to their maximum annual debt service, as well as certain levels of liquidity.
In recent years not-for-profit hospital systems have increasingly relied on the taxable market for debt issuance because of the greater flexibility with respect to the use of proceeds and a 30-year muni-Treasury ratio that has often exceeded 100 percent, according to Goldman Sachs. Similar to the start of the 2009 American Recovery and Reinvestment Act’s Build America Bonds program, however, taxable hospital bonds have seen slow market acceptance, resulting in generally wider risk-adjusted spreads. For example, by our estimates, high-grade, not-for-profit hospital bonds provided much greater option-adjusted spreads than many high single-A and double-A corporate issuers as of early December, primarily owing to the more limited liquidity profile associated with the hospital bonds.
As a result of our expectation for continued deleveraging in the high-grade, not-for-profit health care sector, we believe that tax-exempt hospital bonds offer the potential for attractive incremental yield to the general municipal curve. In addition, taxable hospital bonds should be considered by investors with both a longer-term investment horizon and less need for tax-exempt income.
Frank Cesario is a vice president and municipal credit analyst at Pacific Investment Management Co.’s New York office.
See Pimco’s disclaimer.
Get more on fixed income.
