By Shari Sikes and Art Schloss
Health care reform took center stage in the last year as the Supreme Court upheld the Patient Protection and Affordable Care Act of 2010 (ACA), affirming the constitutionality of portions of the law. The decision made it possible for major health care reform to proceed. This January, health care spending again was at the forefront during the fiscal cliff debate as a means to reduce government spending. Health care is poised to remain at the center of this discussion until a federal budget deal is reached. With the cost of health care garnering so much attention, and with tangible legislation already on the table, it is inevitable that not-for-profit hospitals will face growing, systemic operating pressure during the next several years. Many would also argue that the industry is nearing, or has reached, the peak of its present business cycle.
Since health care represents a notable percentage of bonds across the Invesco municipal complex, we understand this raises several questions for investors, and we have sought to provide answers below.
Where does health care reform currently stand, and what does that mean for not-for-profit hospitals?
With the bulk of the ACA due to go into effect in 2014, there are a surprising number of questions still outstanding on key components of the legislation. We expect 2013 to be a race to the finish line for most hospitals while Washington provides clarity around several substantive issues. Specifically, we will learn which states plan to expand their Medicaid programs, how state insurance exchanges will take shape and how the federal government will implement its insurance exchange activities. Additional questions remain about how the Internal Revenue Service will enforce the individual insurance mandate and how private employers will approach their insurance offering strategies. In short, there is significant ambiguity surrounding the central themes of the ACA, and the current lack of clarity will likely drive unprecedented policy change during the next year. Lingering political opposition and calls for entitlement reform could also prompt additional legislation, adding another layer of uncertainty that could ultimately change how the act is written.
At this point, we know that health care spending in the US grew an unsustainable 80% during the last 10 years, topping $2.7 trillion in 2011. That represents about 18% of the nation's gross domestic product. Since the federal government funds approximately 28%1 of health care spending, reductions in hospital reimbursement rates from Medicare and Medicaid are here to stay, regardless of whether they come as the result of industry reform or entitlement reform. Since not all hospitals and local markets are created equal, and coming policy changes will likely create greater disparity among states, we can also say with certainty that not all hospitals will be impacted in the same way and health care reform will not take place at the same pace across the country.
What are hospitals doing to prepare for the implementation of health care reform?
Most of our conversations with hospital management teams regarding reform center around three key themes — cost containment, consolidation and quality of care. Most not-for-profit hospitals derive more than half their patient revenue from Medicare and Medicaid2 and are already experiencing low reimbursement rates from these programs. Reimbursement rates are scheduled to decline further during the next four years, and hospitals are bracing themselves for declining revenues, which will likely be exacerbated by difficult contract negotiations with commercial health insurance providers attempting to navigate their own reform pressures. As a result, major reductions in labor and supply chain costs have been a chief focus for hospital administrators during the past three years. With the easiest reductions now in place, many are turning their attention to alternate business models and new technologies to gain additional savings. Many of these strategies are encouraged under the ACA, which outlines new payment models and offers incentives to reward better care coordination among health care providers and improved patient satisfaction.
Achieving greater quality and lower costs in such a highly regulated, complex, and capital- and labor-intensive industry is no small feat. To achieve these goals and ultimately survive, hospitals are exploring relationships that cross traditional boundaries of religious and service line segmentation at an unusual pace. Catholic providers are aligning themselves with secular providers; not-for-profits are forming affiliations with for-profit hospitals; not-for-profit hospitals are acquiring health care plans and physicians groups; and hospitals are affiliating with such uncommon partners as long-term care providers, alternative health providers and retail pharmacies. And the list goes on. Remarkably, hospital mergers and acquisitions in 2012 were more than double those that occurred in 2009 when the recession began driving affiliation activity. Since consolidation is a way for hospitals to achieve the scale necessary to remain competitive and grow while still investing in infrastructure as we race to implementation, merger and acquisition activity is expected to remain robust.
Will Medicaid and insurance expansion offset some of the reimbursement stress facing hospitals?
The potential impact of a Medicaid expansion and the launch of insurance exchanges remains to be seen. The Supreme Court ruling last summer made state Medicaid expansion optional in that the federal government cannot reduce or revoke Medicaid funding if states choose not to participate in expansion. As the law is currently written, this creates a funding gap between those people qualifying for federal subsidies and those covered by Medicaid. In essence, the funding gap leaves a significant portion of the estimated 30 million Americans previously expected to receive assistance in covering health insurance costs under the law without aid.3 There are also logistical matters regarding insurance expansion that raise additional uncertainties. Studies have shown that many of the uninsured population live in remote, agricultural areas; are young adults with lower educational achievement, and are immigrant and non-English speaking. Not only does this pose challenges in terms of how federal and state governments will communicate available options, but it also poses challenges with regard to cultural thinking since this segment of the population is often fearful of, or adamantly opposed to, government intervention. Many young adults also do not understand the need for health insurance since most of them are generally healthy. These factors will make targeted consumer education critical to successfully expanding coverage. At best, we believe this transition will likely take several years, making it unlikely we will see a dramatic, near term increase in health care utilization as a result of the 2014 individual mandate. Moreover, even if we do see a surge in people seeking health care, we believe it will probably be short-lived since one of the goals of industry reform is to keep people healthier longer, thereby reducing long-term health care costs. Further complicating the insurance question is the uncertainty surrounding payment rates from the insurance exchanges, which given their governmental sponsorship, are expected to be on par or slightly above Medicare and Medicaid rates. These programs typically pay far less than commercial health care insurers. Therefore, for the exchanges to offset anticipated revenue declines, it will require substantial increases in patient volumes that are, at best, uncertain to occur.
How has the financial health of not-for-profit hospitals been impacted thus far?
Incremental revenue pressure is not new for not-for-profit hospitals. The industry has grappled with a difficult operating environment for several years. Growing bad debt, rising charity care burdens, and flat to declining payment rate increases — from both commercial insurers and government programs — have compressed margins since at least the implementation of the Balanced Budget Act of 1997. Medical advances have shortened hospital stays, increasingly shifting patient care to lower-cost, outpatient settings. These same advances have also driven a rise in competing outpatient clinics and specialty hospitals that have also served to increase market segmentation. During the recession, higher unemployment rates and reduced coverage under employer-provided health care plans caused many consumers to postpone elective procedures, creating further depression in hospital patient counts. While the challenges are abundant, hospitals have been struggling with competition, patient volumes, revenue diversity and strategic alliances for the better part of the last 15 years, and have proven they are very adept at shifting costs as needed to maintain their profitability. During the past three years, hospitals have not only benefited from cost shifting, but have also reaped benefits from significant cost-cutting initiatives, greater operating efficiencies and temporary revenue sources associated with federal incentives to implement electronic medical records. Temporary state provider tax programs have also added revenue to bottom lines from fees paid by hospitals to draw down additional matching funds from the federal government for participation in the Medicaid and Medicare programs. Many have also taken advantage of the low cost of borrowing to restructure their debt into more conservative, fixed-rate modes. While there have no doubt been winners and losers over the course of the past several years, as well as a widening gap between the strongest and weakest players in the industry, the financial profile of the sector has nevertheless improved and most metrics, on average, have reached pre-recession levels, making the industry as a whole better positioned to tackle the challenges ahead. However, those hospitals lagging behind — either in terms of financial position or reform preparation — are likely to deteriorate rapidly in the next few years and could ultimately face closure.
What is Invesco's outlook for the sector and where do you see value?
While the changing health care landscape will likely lead to more investment volatility, we believe the downward pressure in the sector also represents compelling opportunities to capitalize on weaker credit fundamentals in exchange for higher long-run total returns. From a capital preservation perspective, we believe bonds issued by large, multistate and regional health care systems with leading market positions will hold their values reasonably well throughout the anticipated stress of the next few years. These providers benefit from geographic diversity, better revenue diversity among payment sources ( i.e., Medicaid, Medicare and private insurers), and better negotiating leverage with private insurance providers. Because they have achieved scale, their cost structures also tend to be more favorable and their balance sheets tend to be stronger, putting them in a better position to generate healthy cash flow and preserve fundamental credit quality during the reform transition and beyond. Conversely, single-site community hospitals with moderate market shares and higher cost structures will likely suffer credit quality deterioration leading to underperformance. However, the amount of acquisition activity in the industry also makes these lower-quality credits interesting purchase opportunities if our qualitative and quantitative analysis reveals a well-run institution that is reasonably well positioned in its local economy. During times of industry stress, absent technical factors, these bonds will tend to trade at lower prices to compensate for the added risk, potentially leading to higher total returns.
Historically, bonds issued by not-for-profit hospitals have also been among the top-performing sectors of the municipal market and have offered attractive yields relative to many sectors. While the industry is volatile in many regards, we believe some of the volatility is mitigated by the essential nature of the services hospitals provide and the dependence of many local economies on their existence. This makes hospital bonds an attractive alternative to both lower-yielding municipal securities issued by state and local governments and higher-yielding tax-exempt bonds issued by smaller borrowers in often more cyclical sectors of the municipal market.
How is the Invesco municipal bond team preparing for the increased volatility in the health care sector?
We believe the degree of uncertainty that exists in the sector and the anticipated pace of policy change makes credit selection more important than ever. With our team of 16 municipal research professionals, who have an average of 22 years of research experience, Invesco is well positioned to monitor and assess the legislative changes impacting the industry and to conduct the ongoing, qualitative and quantitative analysis necessary to minimize the risks associated with individual hospital holdings. The changes facing the health care industry also highlight the value of a diversified portfolio in limiting downside, systemic risk as the solid economic performance of some hospitals support more stable bond valuations, potentially offsetting price declines of other bonds issued by hospitals with weakening credit fundamentals.
Municipal securities are subject to the risk that litigation, legislation or other political events, local business or economic conditions or the bankruptcy of the issuer could have a significant effect on an issuer's ability to make payments of principal and/or interest. Municipal securities can be significantly affected by political changes as well as uncertainties in the municipal market related to taxation, legislative changes or the rights of municipal security holders. Because many securities are issued to finance similar projects, especially those relating to education, health care, transportation and utilities, conditions in those sectors can affect the overall municipal market. In addition, changes in the financial condition of an individual municipal insurer can affect the overall municipal market.
Credit risk is the risk of loss on an investment due to the deterioration of an issuer's financial health. Such a deterioration of financial health may result in a reduction of the credit rating of the issuer's securities and may lead to the issuer's inability to honor its contractual obligations, including making timely payment of interest and principal.
Interest rate risk refers to the risk that bond prices generally fall as interest rates rise and vice versa.
Lower rated securities may be more susceptible to real or perceived adverse economic and competitive industry conditions, and the secondary markets in which lower rated securities are traded may be less liquid than higher grade securities.
Fixed-income products are subject to risk, including, but not limited to, the effects of changing interest rates. There is no assurance that any investment or strategy will achieve its investment objective.
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