August 3, 2016—In the early days of the Affordable Care Act (ACA), conventional wisdom held that by this time—six years after its passage—hospitals would be well down the road in their transition from fee-for-service payment models to value-based, population health models. Stressors from that shift would be evident in hospital financial performance as would the effects of cuts in Medicare payments. As recently as last year, all three major rating agencies had negative sector outlooks on not-for-profit hospitals.

Conventional wisdom, however, was wrong. Hospital financial metrics remain solid for many hospitals. Benefits from the ACA Medicaid expansion, rigorous cost controls, and slower-than-anticipated payment risk adoption have provided support to credit quality.

Expected stressors are merely delayed (not eliminated), and as they inevitably surface, hospital financial metrics will be affected. According to Moody’s, “Longer term margins should quell given tightening reimbursement, increased pension expense and exhausted cost cutting measures.”

The question is whether we are seeing this already. For the quarters ended December 31, 2015 and March 31, 2016, results for a number of sizable hospital systems exhibited reduced operating margins and, for some, operating losses.

Even a few select systems with a history of remarkably stable results have shown uncharacteristic margin compression. While it would be premature to view these limited results as confirmation of an overall shift in sector performance, given the many pressures facing healthcare systems, it would not be surprising if we have already seen hospital margins peak. Favorably, given the extended time horizon that hospital executives have had to prepare, the step off the peak should be a slope, not a cliff.

Loss of less acute hospital volume
One developing factor, as recently reported by Fitch Ratings, is a reduction in less acute hospital volumes. Fitch notes that less acute hospital volume declined at for-profit hospitals in the first quarter of 2016. It attributes this to payor pressure to reduce short-stay admissions and a focus on reducing readmissions to avoid financial penalties. Other factors included the prevalence of high-deductible health plans which encourage patients to use less expensive settings for care and technological improvements, allowing more complex treatment outside of the acute care setting. Although Fitch’s analysis focused on for-profit companies, these same factors would also affect outcomes at not-for-profit systems.

Transition to value-based
A rising risk factor for hospitals is the transition from revenues based on volume (fee-for-service) to value-based payment models centered on patient outcomes and coordinated care management of high-risk/high-cost patients. If the Centers for Medicare & Medicaid Service (CMS) achieves its goal, 90% of Medicare’s fee-for-service payments will be converted to value-based payments by 2018. Although virtually every hospital is currently in some stage of transition, the majority of payments today remain based on fee-for-service models with risk-based contracts often limited to upside incentives only.

Notably, a recent survey of executives by KPMG indicated that healthcare executives are more pessimistic about value-based contracts than two years ago (52% vs. 49%). Of healthcare providers responding, 25% expect a modest decline in operating income, 21% expect a significant drop, and 6% expect a steep decline. A quarter of respondents expected a neutral impact while 23% expected improved profitability. Respondents named challenges such as less focus on disease management, increased use of telemedicine, and growing connections with “lower acuity healthcare facilities.” Observed Dion Sheidy, KPMG’s Advisory Healthcare Leader: “Healthcare companies need to prepare for a dramatic shift in how they get paid.”

Growing payor clout
Several massive health insurer consolidations are in motion and the impact on hospital margins is unlikely to be positive. Mergers pending regulatory approval include Anthem Inc.’s acquisition of Cigna Corp. for $48 billion and Aetna Inc.’s plan to acquire Humana for $37 billion. Presuming they meet Department of Justice antitrust hurdles, the impact of these mega-mergers will likely not be favorable for hospital bottom lines.

Back-ended Medicare cuts
Provisions within the ACA introduce growing Medicare cuts to providers. For 2017, the CMS proposal for inpatient hospital rates is just 0.7% and incorporates a 0.75% negative ACA adjustment factor. Although future cuts are expected to be even more substantial, a higher proportion of Medicare patients at a hospital already correlates with lower profitability.1 In fact, according to the American Hospital Association, 65% of hospitals received Medicare payments less than cost.2 Since the ACA’s Medicare cuts to providers are back-ended, hospitals have yet to experience their full effects.

On the other hand . . .
Despite our concern that hospital credit quality may be peaking, it is bond prices, not hospital credit quality, that limits our enthusiasm as purchasers. Investor demand for yield, combined with limited supply, is creating razor-thin spreads in the not-for-profit hospital sector. Between early April and late June 2016, already-tight spreads compressed an additional 20 basis points, or bps (0.20%) for double-A category healthcare bonds in the 10-year range. In late June, a 10-year, double-A category healthcare system issued debt at a slim 21bps spread to municipal market data general obligation bonds.3 This is great news for hospital issuers, but not-so-good news for bond purchasers. As such, our appetite for additional not-for-profit healthcare holdings has been subdued.

This analysis was included in our 2Q 2016 Municipal Fixed Income Quarterly Market Review which can be found on the public website.

1Ge Bai and Gerard F. Anderson, “A More Detailed Understanding of Factors Associated with Hospital Profitability,” Health Affairs, June 2016, Vol. 35 No. 6

2American Hospital Association, “Underpayment by Medicare and Medicaid Fact Sheet,” January 2016

3Bloomberg

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