Hospital “Survivor”: Muni Bondholders Wait to See Who Makes the Cut

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

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

Most US hospitals actually have nonprofit status. They don’t pay taxes because they provide free or low-cost healthcare to those who need it. But to attract paying customers, they need enhancements like new cardiology centers, plastic surgery facilities and private rooms. Financing these often means borrowing by 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 they operate. Hospitals that can be more efficient and reduce costs will have a better shot 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% and 75% 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 readmitting patients that weren’t 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 as it is—further revenue cuts would 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 US. 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% 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 head back up in later years. With Medicare and Medicaid amounting to 22% of estimated federal spending, cuts to these programs’ 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% of the new issuance in 2012. But historically, it’s seen a greater share of defaults, bankruptcy filings and credit volatility than other sectors have. 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.

But muni investors can choose from hundreds of issuers in the healthcare sector—from single 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.

Joseph Rosenblum is Director of Municipal Credit Research at AllianceBernstein.

Joseph Rosenblum

Joseph Rosenblum is Director of Municipal Credit Research.

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4 thoughts on “Note to Bond King: Check Your Math

  1. “Does Gross expect that US population will shrink, productivity gains will disappear, and inflation will remain quiescent forever? That is what needs to happen for long-term nominal GDP growth to be as low as 4%.”

    No, that”s not really what needs to happen.

    US population does not have to shrink at all, rather only that it grow less than the “little over 1%” figure indicated.

    US annual population growth rates have generally been below 1% since the early 70s (but for a brief & unsustained surge in the early 90s), and the historical population growth rate trend has clearly been trending downward in the US for over a century now (was nearly 2% around the turn of the last century, and has been in the lower 0.9% for the most recent decade+). During the Great Depression (the last time we went through a Fisherian debt-deflation following a Minsky-ian financial crisis), population growth rates fell from “a little over 1%” to the 0.6% range. Add to the mix the right”s antagonism towards immigration, and it not at all difficult to conceive of relatively lower population growth that the ”norm” suggested by Seth.

    Ditto re: productivity gains: Productivity does not have to actually reverse into negative territory (although that has happened for brief periods of time), rather the rate of productivity gains merely has to slow from the assumed 2% rate, which is entirely reasonable (see, e.g., http://www.bls.gov/lpc/prodybar.htm).

    Over the course of the “Great Moderation” [which is now long gone & replaced by the ''new normal'' of delevering our way out of a balance sheet recession] nonfarm business sector prductivity trended from approx. 1.1% during the 1973~1979 stagflation era steadily upward to 2.5% for the 2001-2007 period of the Bush policy area… only to start falling again (1.8% average for the post-bubble era). Without a clear path out of our current debt-deflation induced economic malaise, it is hard to see how 2%+ productivity gains can be sustained over the next decade in the face of dampened aggregate demand & ongoing deleveraging… unless corporate America resorts to yet more unemployment. It is not all that hard to envision an extended period of low productivity gains of, say, only 1%, as has happened for multi-year steches over the last 40 years.

    As for inflation: Maybe not ”forever”, but perhaps for the next 10 years. Until the private sector”s balance sheets are sufficiently repaired – which then allows aggregate demand to rebound sufficiently to start making a run towards full employment & full use of productive capacity – it is unlikely that inflation is going to consistently generate even your ”modest” 3% target. The Fed has already set a 2% inflation target – which it has barely met even in the face of energy price spikes & a domestic drought”s impact on agricultural commodities – through 2014 ~ 2015. With Europe on its knees, unemployment stubbornly high & capacity utilization stubbornly low, and the US dollar still the reserve currency of choice, there is little if any inflationary pressure anywhere, that I can see.

    So, at the end of the day, all that is needed to see 4% nominal equity returns is, let”s say (just for the sake of argument), 0.7% population growth + 0.7% productivity growth, then real stock returns are a measly 1.4%. What is unreasonable with that? A bit pessimistic, perhaps, but certainly not unreasonable.

    Add back the Fed”s targeted 2% rate and you get 3.4% nominal equity returns… below Gross” estimate, without much stretch of the imagination at all. And without population shrinkage or productivity collapses of any sort.

    • Your scenario is possible, but it’s just one scenario, and not the most likely one, in our view. In any case, even 3.4% nominal equity returns would beat prospective long bond returns. You’d still get to Dow 20,000, but it would take longer. In my next blog post, I will discuss a number of different scenarios and how long it would take the Dow to reach 20,000

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