The Rise, Fall, and Future of Not-for-Profit Hospital Debt Issuance
“With just 333 bond issues in 2011, not-for-profit hospital debt issuance dropped 17% year-over-year to approximately $23.9 billion. Of this amount, only $10.3 billion were used for new money purposes, while the remaining $13.6 billion was used for refunding purposes.”
- Wells Fargo Securities Municipal Commentary
The municipal bond market faced a rocky year in 2011, with no sector immune to the pressures of the capital markets. Debt issuance in the not-for-profit hospital sector continued its decline in 2011 due to uncertainty in the municipal market as well as changing dynamics in the healthcare industry.
While the need for funding doesn’t disappear when funding sources do, many hospitals - like other public sector entities - have been forced to stretch their dollars further, “make do” with current facilities, and re-evaluate their capital plans.
In the interview that follows, George Huang, Senior Analyst and Municipal Strategist at Wells Fargo Securities, LLC, explains the factors that influence municipal bond trends in the not-for-profit hospital sector.
MuniNet: Let’s start with the basics ... Why do not-for-profit hospitals issue debt?
Huang: Hospitals operate on a cash flow basis, using incoming revenue to cover day-to-day expenses and overall operational costs. Cash flow is generally used for capital expenditure, or “capex,” purposes on an ongoing basis throughout the year, but when a hospital administration decides to make strategic facility improvements, they usually turn to alternative funding sources. Long-term debt issuance is typically used to finance long-lived assets, and particularly for large capex needs.
Hospitals also issue debt to reimburse themselves for prior capex outlays - they will do this on a periodic basis once they have accumulated a significant amount of capex. Debt issuance makes sense if hospitals can obtain a good cost of capital and can adequately reinvest the bond proceeds while they are in the construction phase. This way, hospitals can infuse cash into their coffers for purposes of redesigning an emergency room, building a new patient tower, or constructing a physician clinic, instead of draining their existing cash on hand.
Nowadays, some hospitals are also using debt to finance enhancements in their information technology systems so that they can achieve electronic medical records capabilities. This is a new development. Although the IT systems are not long-lived like bricks and mortar projects, complete system overhauls are typically quite expensive so shorter-issue maturities of say 5 to 7 years in the context of a larger debt issuance could make sense.
In 2011, 43 percent of not-for-profit hospital bond proceeds were used to finance these types of “new money” capital projects. The remainder was used for refunding transactions.
MuniNet: Why was such a large percentage of overall debt issued for refunding purposes in 2011?
Huang: Since the financial crisis and the recession, we have seen significantly higher refunding activity in the not-for-profit hospital sector. In 2011, we saw a continuation of that trend, although the pace of refundings began to slow. Lower interest rates and a desire to move to a more conservative capital structure prompted many not-for-profit hospitals to restructure their outstanding debt. In the early to mid 2000s, many issuers turned to variable rate securities because low interest rates and good investor demand for these types of debt products made their cost of capital quite attractive. Variable rate securities quickly became the predominant form of issuance for hospitals, accounting for 60-70% of total par issued in the sector. The increased penetration of bond insurance during this time was also a factor - a majority of hospital debt was being wrapped by bond insurers and trading of the insured paper was relatively liquid.
Insured auction rate securities were a popular lower-cost, variable rate financing vehicle, but when the financial crisis began in late 2007, the market’s support for auction rate securities (ARS) collapsed. A lot of insured variable rate demand obligations (VRDOs) were supported by standby bond purchase agreements (SBPAs) from banks. In 2007 into 2008, the trouble in the bond insurance industry aligned with the escalating fiscal crisis. The problems with sub-prime mortgage securities, which many bond insurers insured, exerted profound pressure on the capital markets and banks. So in 2008, almost overnight, many hospitals saw their interest rates climb dramatically for ARS and VRDOs.
In 2011, 43 percent of not-for-profit hospital bond proceeds were used to finance these types of “new money” capital projects. The remainder was used for refunding transactions.
The sudden drop in investor demand for these types of securities (which were somewhat disproportionately represented in the hospital sector) and concerns about counterparty bank risk, led to higher variable rate interest rates across the board. This quickly turned into a vicious cycle, as many investors (particularly in the retail market) found variable rate hospital bonds too expensive - and too risky - for their portfolios, which made the situation worse.
Since the interest rates on their variable rate securities were skyrocketing and hospitals were finding that there was no liquidity for their bonds, hospital management teams at that point made the prudent decision to restructure into other modes, such as fixed-rate. It also helped that absolute interest rates came down over the past few years because of the recession and the Fed’s monetary policies. Hospitals had added incentive to restructure their debt because the low interest rates made it even more economical to refinance their bonds using a more conventional financing structure.
Much like we’ve seen with consumers refinancing home mortgages, there have been some incredible opportunities for hospitals to lock-in long-term, low fixed-rate borrowing costs. By 2009, the issuance pattern was reversed, with over 70% of debt issued in fixed-rate mode. With interest rates so low, we expect the majority of debt issuance to still be issued in fixed-rate mode for the next year, but some of the stronger institutions are beginning to return to variable rate debt as a financing option.
MuniNet: What factors have contributed to the decline in debt issuance in the not-for-profit hospital sector in recent years?
Huang: There are a number of factors that have impacted debt issuance. As a whole, the not-for-profit hospital industry began feeling fiscal stress as early as 2008, when the economic downturn began to negatively impact underlying hospital operations - patient utilization dropped off precipitously in a short period of time and has stayed at low levels or only grown modestly since, to the surprise of many in the industry. Clearly, this past recession was more severe than previous ones, so there are a lot of uninsured or under-insured citizens. Consumer psychology has played a bigger part in the recovery because there is greater cost-sharing for employer-sponsored insurance, such as higher premiums, co-pays, deductibles, and co-insurance. In addition, there has been an increase in the level of consumer-driven healthcare. All of these factors have combined to limit growth in patient utilization.
In addition, healthcare reform pushes for better quality care and the reduction of duplicative or unnecessary services. Starting this fall, the equation is changing. Prior to the recession and health care reform legislation, hospital capital plans used a different business model than they will have to use going forward. Up until now, hospitals have been reimbursed under a Fee-for-Service model. In other words, every time a patient sees a doctor or uses a service, the hospital could bill for the services and get paid for it.
So in the past, hospital management teams based their capital plans for expansion and improvements on an analysis of their actual patient volume growth, as well as expected utilization growth based on demographic growth trends and projections and real estate market trends. Along with the boom in the real estate market, there was strong population growth in many areas, so in some instances there was a little bit of a “build-it-and-they-will-come” mentality among some hospital administration teams. Based on the growth assumptions and real evidence of population and patient growth, the drive to build replacement hospitals and/or expand existing facilities was usually well justified.
However, as the recession became deeper and the recovery appeared slower, new trends in patient utilization emerged. Patients began to exercise more restraint in using healthcare services, essentially “self-regulating” themselves - on a wide scale basis. Patients postponed elective procedures, delayed seeking care and generally opted to stay away from hospitals in non-emergency situations. With overall healthcare utilization dropping and certain reform provisions expected to drive “excess” utilization out of the system, hospitals have shifted their capital priorities. Management teams began asking themselves, “Do we really need this project?” and “Can we make the project less expensive and achieve the same goals?” Many hospitals needed to reassess their businesses so they were more inwardly focused. Improving operational efficiency, deleveraging and restructuring debt and swap exposure have been key themes the past few years.
Access to capital markets has also been a significant factor influencing debt issuance in the not-for-profit hospital sector. It has been more expensive for smaller and lower rated hospitals to issue debt so many of them have held off on issuing debt so they can get a better cost of capital.
MuniNet: How has the “flight to quality” among investors impacted the not-for-profit hospital sector?
Huang: Uncertainty in the economy and health care reform have resulted in a shift among both institutional investors and retail investors. We are seeing a preference for higher-rated names, and less interest for smaller, lesser-known or lower-rated hospitals. This impaired access to the capital markets has made borrowing costs for lower investment grade (or weaker) issuers prohibitively high in some cases, in essence, shutting many hospitals in this category out of the marketplace for now.
MuniNet: In addition to a lower number of not-for-profit hospital debt issues coming to market, what trends have you noted in terms of issue size?
Huang: For the first time in 10 years, no single issue broke the $500 million barrier in 2011. While this is a somewhat arbitrary cut-off number, it does suggest that in the past, the average bond deal could be quite large. Since the changing dynamics in the healthcare sector have resulted in a shift in priorities for many not-for-profit hospitals, we don’t think that we’ll be seeing as many large deals this next year. Redesigning the healthcare system to focus on increased efficiencies and improved quality of care is less expensive so it has reduced the capital requirements for many not-for-profit hospitals and hospital systems. Therefore, we have seen a decrease in long-term debt issuance for more expensive brick and mortar purposes. There will still be these needs, but we think it will be more modest. We are also seeing an increase in shorter-term maturities for improvements and projects that will amortize more quickly, such as for electronic medical record systems and information technology upgrades.
Management teams began asking themselves, “Do we really need this project?” and “Can we make the project less expensive and achieve the same goals?”
However, many of the higher-rated, better-known names in the sector did bring new issues to the market in 2011, and we expect that trend to continue in the coming year. Because interest rates and yields have come down so much, this is a really good time to come back to the market to finance long-term projects.
MuniNet: How would you describe merger and acquisition activity in this sector?
Huang: Reform and concerns about decreased reimbursement has accelerated merger and aquisition (M&A) activity in the sector in recent years. Many hospital management teams believe that they will need size and scale to be able to adequately compete and survive in the new healthcare world. Hospitals are beginning to look at strategic growth again. They are looking at M&A for consolidation, cost-sharing synergies, and partnerships and alliances for growth opportunities. These things will require debt at some point. We are seeing a lot more variety in strategic partnerships and alliances as well so it will be quite interesting to see how things develop this next year.
MuniNet: How might pending healthcare reform legislation impact not-for-profit hospital debt?
Huang: It will be very interesting to see what the Supreme Court decides on the constitutional challenge to the healthcare reform law. It’s possible that the entire law will hinge on the question of whether the individual mandate is legal. We think that severability of the mandate will be overturned so if the mandate is illegal, then the entire law could be struck down. But regardless of the outcome, we believe that hospitals will have to contend with provider reimbursement cuts and some form of reform.
There is a lot of downward pressure on federal reimbursement because of the federal budget deficit, so we think that Congress will still look to take out significant dollars from healthcare even if the Accountable Care Act is overturned. Hospitals have made a lot of investments in reengineering the delivery system so it will be hard to reverse the strategic, organizational and operational restructuring initiatives that they’ve been implementing. These changes have gone past the tipping point, in our opinion, so there’s really no going back at this point.
What they are doing to change the delivery system should be beneficial to everyone theoretically, but is going to be a bit painful to get there. Hospitals have done a good job becoming more efficient the last few years, but making the next steps in improving efficiency while all forms of reimbursement are going down and while reform related changes are increasing expense pressures will be hard.
MuniNet: What trends can we expect to see in not-for-profit hospital debt issuance in 2012?
Huang: We believe that not-for-profit hospital volume will increase in 2012 due to pent-up demand for capital expenditures. Many hospitals have waited for the right time and conditions to issue debt for new money purposes; we expect to see an increase in volume for strategic capital improvement projects, as well as for reform-driven changes in healthcare delivery systems. Many hospitals have been holding off on debt and they can’t wait much longer, or else they will run the risk of depleting their cash liquidity or risk falling behind their competitors that are making facility improvements.
With increased hospital bond supply and a greater diversity of issuers, we think that bond yields and credit spreads will widen, since investors will be able to be more selective about their investment decisions. It’s a tough operating environment so we also think there will be a greater number of negative outlooks and ratings downgrade assignments in the next year. That will also have an impact on the level of investor demand.
We expect to continue to see a lot of refunding activity in 2012, but we think this will taper off because hospitals have taken advantage of most major restructuring opportunities.
MuniNet: We’ve recently heard about some not-for-profit hospitals turning directly to banks for financing, bypassing the municipal market altogether. Do you see this as an emerging trend - or a short-term solution for a limited number of hospitals?
Huang: For the past 18 months or so, hospitals have been increasingly looking at direct placement (DP) bank loans as an alternative financing structure to VRDOs. Hospitals are either refinancing their outstanding bonds or choosing this approach right out of the box. In many ways, it’s a “win-win” situation. In going this route, hospitals have been able to find attractive terms that make their cost of capital as good or better than with traditional VRDOs - the debt is still variable, but some of the potential problems can be mitigated.
With DP loans, hospitals can avoid remarketing risk associated with VRDOs since they can lock in their spread to some variable index for typically between 3-5 and even 7 years. Hospitals are usually able to negotiate a “soft-put” feature which provides them with protection for a period of time to restructure their loan if something adverse happens to the hospital’s credit quality or if the underlying base variable interest rates spike for external factors.
From the bank’s perspective, they are able to eliminate a contingent liability from their balance sheet - in other words, the accounting treatment is different for a SBPA or a Letter of Credit that may come into play versus the accounting treatment they would use to book a loan that is more advantageous to a bank. We think there will be healthy DP volume this next year, particularly for the stronger names, a trend that holds the potential to continue to suppress bond volume to a degree.
About the Expert
George Huang has more than 14 years of municipal finance experience, including a decade of experience in the not-for-profit healthcare space both acute care and long-term care. He is currently a director and senior analyst in the municipal research department at Wells Fargo Securities, LLC.
Prior to Wells Fargo, George was a director at Assured Guaranty, a bond insurance company, where he managed the healthcare risk management group. He has also held positions at Radian Asset Assurance, Mizuho Corporate Bank, and Moody’s Investors Service.
George is a member of the Healthcare Financial Management Association, the National Federation of Municipal Analysts and the Municipal Analyst Group of New York. He holds a bachelor’s degree from the University of Pennsylvania.
Copyright © 2012, MuniNet Guide