The policy outlook for U.S. not-for-profit (NFP) healthcare has stabilized somewhat after a turbulent 2017, when repeated congressional attempts to repeal and replace the Affordable Care Act (ACA) and uncertainties about tax reform tested the sector. Despite these credit headwinds, bond spreads tightened significantly over the course of the year in all rating categories, marking a return to more normal levels after having widened substantially following the November 2016 elections (see Figure 1). With help from a favorable technical environment, healthcare ended 2017 as the best-performing investment-grade muni bond sector (see Figure 2).
We expect the favorable technical backdrop to support continued relative outperformance this year, but note that credit challenges – including rising labor costs and lower reimbursement – remain in play. Active credit selection will therefore continue to drive performance, and we maintain our bias in favor of higher-quality issuers. We expect an aging population and other demographic changes in the U.S. to result in higher utilization of healthcare services. However, reimbursement challenges will limit top-line revenue growth, and rising healthcare costs will likely spur greater price awareness among consumers, employers and lawmakers. This will require NFP health systems to make sizable investments to redesign their care delivery systems to provide lower-cost, higher-quality patient care. Strong credit fundamentals will be paramount to support these investments.
Insights for 2018: Remain invested, with a focus on quality
We expect a more stable federal healthcare policy environment this year, as future efforts to fully repeal the ACA are unlikely to be successful. While the U.S. tax reform bill passed in December 2017 included a repeal of the ACA’s individual mandate penalty (effective in 2019), Medicaid remains intact as an open-ended entitlement program for approximately 70 million Americans. Additionally, the recently passed federal budget included 10 years of funding for the Children’s Health Insurance Program (CHIP), delayed the ACA’s disproportionate share hospital (DSH) cuts by two more years, renewed so-called Medicare “extenders” and eliminated the Independent Payment Advisory Board (IPAB) – all generally favorable for NFP health systems.
Credit challenges remain, however, including rising uninsured and “underinsured” patient populations, which will result in higher uncompensated care and lower revenue growth for NFP health systems. ACA market enrollment declined by 3.8% during the open enrollment period for the 2018 plan year,1 and we expect this trend to continue over the next several years. An increasing number of patients with high-deductible health plans will also negatively affect revenue collections for NFP health systems. This is key at a time when rising labor and pharmaceutical costs are already resulting in margin contraction for many NFP health systems.
Issuance is set to fall
We expect a significant decline in U.S. federal tax-exempt healthcare muni issuance after a spike to record-breaking levels in December 2017 (tax exemption refers to interest income and is limited to U.S. residents). Issuers rushed to the market late last year amid fears of a U.S. tax reform proposal that would have eliminated private activity bonds (PABs), the primary vehicles through which NFP health systems issue U.S. federal tax-exempt debt. We estimate that roughly $10 billion of healthcare issuance was pulled forward into December 2017. While healthcare has represented 11% of muni issuance for the past two years, this figure has dropped to just 4% of new debt to date in 2018. If this trend continues, the resulting scarcity value should provide a tailwind for healthcare spreads.
While we expect healthcare spreads to provide relative outperformance versus other muni bond sectors given a supportive technical backdrop, selecting and investing in the most promising credits will remain vital given reimbursement pressure and growing expenses in the sector. The benefits of Medicaid expansion – namely, a lower uninsured rate and higher utilization – peaked in 2015, and revenue growth slowed in 2016 and 2017. State-specific changes to Medicaid programs, including work requirements, could result in an increase in the uninsured rate in certain markets. Shifting utilization trends from inpatient to outpatient services, increasing use of high-deductible health plans and a growing Medicare population will also limit revenue growth. Low unemployment and a nationwide nursing shortage are pushing labor costs up, and rising costs for medical supplies and pharmaceuticals will also continue to pressure many NFP health systems’ operating performance.
For these reasons, we remain underweight and cautious on single-site hospitals, rural hospitals, and health systems that rely heavily on governmental payers. These types of providers are generally less able to respond swiftly to operating pressures.
Merger mania will likely continue
We expect continued consolidation in the sector in response to the operating challenges highlighted above, through both horizontal and vertical mergers and acquisitions. As Figure 3 shows, the crescendo of health system mergers in recent years reached a new high in 2017,2 and we expect the trend to continue this year. Mergers can benefit NFP health systems by improving their bargaining power with managed care and commercial payers, and over the longer term, generating cost savings and producing synergies and integrated care. But we believe bigger is not necessarily better; mergers are challenging to execute and often result in increased leverage and weakened operating performance in the initial years of integration. We prefer regional health systems with strong credit quality and good market positions to lower-rated multistate systems and single-site hospitals. In our view, regional health systems offering services across a continuum of care are nimble enough to respond to their local market dynamics, but large enough to achieve economies of scale.
Beyond 2018: a high-cost industry ripe for disruption
As healthcare spending increases and becomes a larger and larger segment of the U.S. economy, we believe the sector is poised for disruption. National health expenditures are projected to reach nearly 20% of total U.S. GDP by 2026,3 driven primarily by rising prices for medical services and shifts in enrollment from private insurance to Medicare as baby boomers age (see Figure 4). While we do not anticipate major U.S. entitlement reform in 2018, we expect the federal government will eventually be forced to make cuts to Medicare and Medicaid due to large looming federal deficits. We view such declines in federal reimbursement as a key risk for the sector.
In addition, as out-of-pocket healthcare costs rise, we expect NFP health systems will continue to face scrutiny from consumers, employers and public officials. This will require greater transparency and the need for NFPs to demonstrate that they can provide better value and improved care coordination for patients. If NFP health systems cannot deliver, patients will seek care in lower-cost and more convenient settings. For example, recently announced vertical integrations of non-hospital providers, such as CVS and Aetna and potentially Walmart and Humana, could result in patient care increasingly being delivered outside of an NFP health system’s network. Employers’ focus on reducing healthcare costs – as exemplified by the Amazon/Berkshire Hathaway/JPMorgan partnership – also has the potential to be disruptive for the sector.
We believe successful NFP health systems of the future will offer vertically integrated networks of physicians and other non-hospital facilities, patient-centered care delivery models, pricing transparency and a strong value proposition for consumers. Achieving these capabilities will require substantial investments, so strong underlying credit fundamentals are essential. Thoughtful management teams, good balance sheets and operating performance, and a strong market position are the key characteristics PIMCO looks for when investing in NFP health systems.
To receive up-to-date municipal market insights from PIMCO, subscribe to our Muni Insights list.
(Generally one to three key emails per quarter. Unsubscribe at any time.)
1 See “Health Insurance Exchanges 2018 Open Enrollment Period Final Report,” published April 2018 by the Centers for Medicare & Medicaid Services.
2 See “2017 in Review: The Year M&A Shook the Healthcare Landscape,” by Kaufman, Hall & Associates, LLC.
3 See “National Health Expenditure Projections, 2017–26: Despite Uncertainty, Fundamentals Primarily Drive Spending Growth,” published 14 February 2018 by Gigi A. Cuckler, Andrea M. Sisko, John A. Poisal et al.