Healthcare “Survivor”: Muni bondholders wait to see who makes the cut

March 15, 2013

This is a guest post from Joseph Rosenblum, the Director of Municipal Credit Research at AllianceBernstein.

To stay solvent, hospitals run a numbers game, charging high prices to patients with private insurance to offset lower payments from Medicare, Medicaid and the uninsured. Some hospitals make a nice profit; others struggle. Now hospitals are facing a game changer – the Affordable Care Act, which expands Americans’ access to medical insurance, but changes the reimbursement rules to care providers.

How will this affect hospitals’ bottom lines and their ability to pay off debt?

Most hospitals in the United States have non-profit status. They don’t pay taxes because they provide free or low-cost healthcare to those who need it. To attract paying customers, hospitals need enhancements like new cardiology centers, plastic surgery facilities and private rooms. Financing these things often means issuing municipal bonds.

Whether the Affordable Care Act will be a boon or bust for hospitals is unclear, but its implementation will change the way that they operate. Hospitals that are more efficient and reduce costs will have better shots at survival. But can they also continue to make their bond payments?

Here are some things bondholders need to know.

Revenue and profit projections are in flux right now. Hospitals get between 25 percent and 75 percent of their revenue from Medicare (federal funding) or Medicaid (federal and state funding) – programs that serve the elderly and poor. Under the Affordable Care Act, millions of previously uninsured patients will have Medicaid or other insurance. That sounds like a good thing. But there’s a catch.

Hospitals must meet stricter standards to receive those federal and state dollars. They’ll be penalized for errors and if they re-admit patients that were not adequately cared for the first time. They’ll also be docked unless they make measurable improvements in the quality of care. The big question: will treating fewer uninsured patients make up for these reimbursement reductions?

Margins for hospitals are in the low single digits. Further revenue cuts would only add to the pain. Ultimately, the industry may face up to $300 billion in reductions to Medicare payments through 2019, according to Moody’s Investors Service. The lower-reimbursement, higher-volume formula will only work for hospitals that can make the required cost cuts and efficiency improvements.

The federal government’s debt problems may cut into reimbursements. Medicaid covers 60 million people across the U.S. Based on government estimates, that could grow by 17 million if all states take the option to extend coverage to those in need. From 2014 to 2016, the federal government will pay the entire cost of covering newly eligible beneficiaries, and it will pay 90 percent or more in later years.

At least, that’s what the government says now.

According to the Congressional Budget Office, the federal government is expected to run a deficit of $845 billion in fiscal year 2013. That will decline to $430 billion in 2015, but turn upward up in later years. With Medicare and Medicaid amounting to 22 percent of estimated federal spending, cuts to payments to hospitals will likely be part of legislation to reduce the long-term deficit.

Not all hospital bonds are bad news, but it’s important to be selective. The hospital sector is a small part of the municipal market – only 9 percent of the new issuance in 2012. But historically, it has seen a greater share of defaults, bankruptcy filings and credit volatility than other sectors. Still, yields are so high that hospital bonds are among investors’ favorites – and that means issuers can get away with offering fewer safeguards.

Today, investors are allowing even A rated (and some BBB+ rated) hospitals to issue bonds with just a pledge of gross revenues as the fundamental collateral. In the past, a mortgage of hospital properties and a debt-service reserve fund would have been required.

Muni investors can choose from hundreds of issuers in the healthcare sector – from independent hospitals to internationally known research centers to multi-state, multi-hospital systems. All of these will likely face difficult challenges; the ones that succeed will keep their balance sheets strong and build efficient, high-quality operations. Many will need to cut costs through economies of scale to stay profitable. Mergers and joint ventures will probably increase.

How can investors decipher which hospitals will thrive in the years ahead? In our view, careful research is the best medicine.

The views expressed herein do not constitute research, investment advice or trade recommendations and do not necessarily represent the views of all AllianceBernstein portfolio-management teams. Past performance of the asset classes discussed in this article does not guarantee future results.

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