Municipals
TheGrowingDispersionintheMuniHospitalSector
4 mins
U.S. hospitals have faced unprecedented levels of operational and financial stress since the onset of COVID-19 when patient utilization rates cratered and costs skyrocketed. Since then, sector performance has varied significantly. While state and local aid, along with management-led initiatives, boosted profitability for some hospitals, volatile investment markets, inflationary pressures, and significant labor shortages hurt others. Consequently, the hospital municipal bond sector has become increasingly disperse, with certain providers greatly outperforming while others continue to struggle. Instead of viewing the hospital sector as a monolith, optimistic that a decline in expenses related to supplies and staff will boost margins industry wide, we believe a more nuanced approach is in order. Rapidly changing dynamics in the hospital sector currently present an opportunity to generate alpha by investing in certain subsectors and geographies while actively avoiding others.
Early in the pandemic, patient utilization at hospitals dropped while costs rose precipitously. In response, the federal government provided healthcare providers with more than $135 billion of direct aid. Increased flexibility—most notably the expansion of telehealth as well as enhanced insurance coverage and payment rates—also supported operations. Greater flexibility, along with robust capital market activity, helped materially boost hospital profitability in 2021. However, weaker capital markets, inflationary pressures, and significant labor shortages resulted in a sharp decline in profitability and liquidity metrics the following year. Rating agency actions followed suit, with downgrades greatly outpacing upgrades in 2022 and 2023 (Fig 1).
Figure 1
Moody’s Upgrades to Downgrades Ratio
Moody’s Investors Service as of April 2024.
Since then, sector improvement has been highly variable and the gap between the strongest 20% of providers and the weakest has never been larger. While the median hospital operating margin ended 2023 at 2.3%, 40% of all providers continue to lose money, and the poorest performing hospitals currently show negative operating margins of -4% to -19%, according to consulting firm Kaufman Hall (Fig 2).
Figure 2
U.S. Hospital YTD Operating Margin Index (%)
Kaufman Hall as of February 2024.
Conversely, the highest performing providers rebounded sharply in the last year, strongly outperforming the rest of the sector. Hospitals now showing higher operating profitability are those less reliant on contract labor, with shorter average lengths of stay and higher outpatient revenue.
Labor Challenges
Labor dynamics also appear to be a key determinant of hospital performance. A deeper dive into performance across geographies shows that providers in the south and southwest have mostly outperformed those located in other markets. This can primarily be attributed to fewer labor challenges and growing population bases, which helped lift patient volumes. With labor supply emerging as the greatest stress factor over the last two years, we believe providers located in areas with growing populations are best positioned to thrive in an increasingly bifurcated hospital market (Fig 3).
Figure 3
U.S. Population Growth
U.S. Census Bureau as of May 2023.
A Disperse Market
The rapidly changing dynamics of the sector post pandemic has created winners and losers, with high-performing hospitals continuing to increase their outperformance versus peers. Single-state systems with sizable footprints appear to be outperforming most other subsectors, including large multistate systems that were historically stable. Another bright spot has been children’s hospitals, which have mostly outperformed. Providers with ancillary insurance operations and highly focused providers in demographically favorable locations are also attractive. We view ancillary insurance operations positively as they act as a hedge against hospital volumes while positioning providers favorably for the gradual shift toward value-based care.
Conversely, small single-site and rural hospitals remain highly stressed as they compete for a limited pool of labor. In this latter category, we would include providers in the Pacific Northwest, which has experienced protracted labor challenges, as well as smaller providers in the East and in the Midwest that lack size and scale, market clout, and growing economic bases. While there have been very few actual payment defaults, some providers have requested covenant relief related to debt service coverage and liquidity tests over last couple years.
An Active Approach
Hospitals deferred capital spending during the pandemic to bolster their balance sheets, and this will need to be addressed as interest rates stabilize and hospital finances recover. As a result, we expect more issuance—specifically from not-for-profit hospitals—over the next two years. The potential for higher issuance is reason to be cautious.
At the same time, hospital municipal bond spreads have tightened significantly from the pandemic wides of 2020 and are currently near their 52-week tights (Fig 4). However, we continue to upgrade our hospital positions through relative value trades and by opportunistically adding new issues when we believe we are being adequately compensated.
Figure 4
Healthcare Municipal Bond Spreads to IG Corporates (bps)
Bloomberg as of May 2024.
As the sector has become increasingly bifurcated, a more active approach to credit selection is required. Subsector, location, demographics, and issue selection has only increased in importance. We are gravitating to higher-rated names that fit our previously mentioned criteria versus the lower-rated end of the market where we don’t believe investors are being adequately compensated for the risks. We currently favor the AA ratings category over the A ratings category given recent compression. We also see value in structures with mandatory put options versus bullet maturities (e.g., longer final maturity bonds with a shorter put feature can trade at a healthy premium to bullet maturities). Should hospital bond spreads widen from here, we are prepared to shift strategy and focus on lower-quality ratings categories to pick up additional yield/spread on a risk-adjusted basis.
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