Category Archives: Credit Upgrade

The Implications of Losing Access to Tax-Exempt Financing

Posted on by • Posted in Credit Downgrade, Credit Management, Credit Quality, Credit Ratings, Credit Upgrade, Health System, Hospital, Hospital Industry, Market Consolidation, Market Trends, Market Uncertainty, Tax Exempt Debt, Tax Exempt Status, Tax-Exempt Status • Leave a comment

https://www.kaufmanhall.com/insights/thoughts-ken-kaufman/implications-losing-access-tax-exempt-financing

On January 17, 2025, a list of potential cost reductions to the federal budget was released by Republicans on the House Budget Committee. The list is long and covers the federal budget waterfront, but it spends considerable time focusing on reductions to healthcare spending. This laundry list of cost reductions is important because the highest priority of the Trump administration is a further reduction in federal taxes. A reduction in taxes would, of course, reduce federal revenue; if federal expenses are not proportionately reduced then the federal deficit will increase. When the deficit increases then the federal debt must increase and at that point the overall impact on the American economy becomes concerning and possibly damaging. There has already been much public speculation as to how the Federal Reserve might react to such a scenario.

It is not possible right now to highlight and describe all of the House budget proposals, but one proposal absolutely stands out: The suggestion to eliminate the tax-exempt status for interest payments on all municipal bonds, or potentially in a more targeted manner, for private activity bonds, including those issued by not-for-profit hospitals. Siebert Williams Shank, an investment banking firm, described the elimination of tax exemption for municipal bonds as “the most alarming of the proposed reforms impacting non-profit and municipal issuers.”[1] This is certainly true for hospitals, since over the past 60 years the growth and capability of America’s hospitals has been substantially constructed on the foundation of flexible and relatively inexpensive tax-exempt debt. Given all of this, it is not too early to begin speculating on the impact of the elimination of tax-exempt debt on hospital finances and strategy.

We should also point out that a separate topic is under discussion, related to the potential loss of not-for-profit status for hospitals and health systems. Such a maneuver could potentially expose hospitals to income taxes, property taxes, and higher funding costs. For now, that is beyond the scope of this blog but may be something we write about in future posts.

Below is a series of important questions related to the elimination of tax-exempt financing and some speculations on the overall impact:

  1. What immediately happens if 501(c)(3) hospitals lose the ability to issue tax-exempt bonds? Let’s treat fixed rate debt first. Assume for now that only newly issued debt would be affected and that all currently outstanding tax-exempt fixed rate debt would remain tax-exempt. We could see an effort to apply any changes retroactively to existing bonds, but we view that as unlikely. Therefore, our current expectation is that outstanding fixed-rate debt would not see a change in interest expense.

    However, it is possible that outstanding floating rate debt would immediately begin to trade based on the taxable equivalent. Historically the tax-exempt floating rate index trades at about 65% of the taxable index. The difference between the tax-exempt and taxable floating rate indices in the current market is 175 basis points. For every $100 million of debt, this would increase interest expense by $1.75m annually.
  2. How would new hospital debt be issued? New debt would be issued in the municipal market on a taxable basis or in the corporate taxable market. The taxable municipal market would need to adapt and expand to accommodate a significant level of new issuance. The concern in the corporate taxable market is greater. Currently, the corporate market requires issuance of significant dollar size and generally the issuer brings significant name recognition to the market. Many hospitals may have difficulty meeting the issuance size of the corporate debt market and/or the necessary market recognition. As such, smaller and less frequent issuers would expect to pay a penalty of 25-50 basis points for issuing in the corporate market.
  3. If tax-exempt debt goes away will certain hospitals be advantaged and others disadvantaged? Larger hospitals with national or regional name recognition that issue bonds with sufficiently large transaction size and frequency will likely borrow at better terms and lower rates. Smaller- to medium-sized hospitals may find borrowing much more difficult, and borrowing may come with more problematic terms and/or amortization schedules and likely higher interest rates.
  4. Will borrowing costs go up? The cost of funds for new borrowings would increase for all hospital borrowers. For a typical A-rated hospital, annual interest expense would increase by approximately 30%. For example, in the current market, on $100 million of new debt, average annual interest expense would increase by $815,000 annually.
  5. Will debt capacity go down? All other things being equal, interest rates will go up and hospital debt capacity will go down. Also, if the taxable market shortens amortization schedules, then that will decrease overall debt capacity as well.
  6. What would the impact of the elimination of tax-exempt debt be on synthetic fixed rate structures? Hospitals have long employed derivative structures to hedge interest rate risk on outstanding variable rate bonds and loans. The loss of tax-exemption for outstanding variable rate bonds and loans would precipitate an adjustment to taxable rates, but corresponding swap cash flows are not designed to adjust. Interest rate risk is hedged, but tax reform risk is not. The net effect to borrowers would be an increase in cost similar to the cost contemplated above for variable rate bonds.
  7. What are the rating implications of the elimination of the tax-exempt market? Rating implications will be varied. Hospitals with strong financial performance and liquidity are likely to absorb the increased interest expense of a taxable borrowing with little to no rating impact. In fact, over the past decade, many larger health systems in the AA rating categories have successfully issued debt in the taxable market without rating implications despite a higher borrowing rate. Even amid the pandemic chaos of 2021, numerous AA and A rated systems issued sizable, taxable debt offerings to bolster liquidity as proceeds were for general corporate purposes and not restricted by a third-party, such as a bond trustee.

    Lower-rated hospitals with modest performance and below-average liquidity will be at greater risk for a downgrade. These hospitals may not be able to absorb the increased interest expense and maintain their ratings. While interest expense is typically a small percentage of a hospital’s total expenses, it is a use of cash flow.

    We do not anticipate the rating agencies will take wholesale downgrade action on the rated portfolio as there would likely be a phase-in period before the elimination occurs. Rather, we expect the rating agencies will take a measured approach with a case-by-case evaluation of each rated organization through the normal course of surveillance, as they did during the pandemic and liquidity crisis in 2008. A dialogue on capital budgets and funding sources, typically held at the end of a rating meeting, would be moved to the top of the agenda, as it will have a direct impact on long-term viability.
  8. How would the loss of the tax-exempt market impact the pace of consolidation in the hospital industry? If a hospital cannot afford the taxable market, then large capital projects would need to be funded through cash and operations. This inevitably will limit organizational liquidity, which will lead to downward rating pressure. Some hospitals, in such a situation, will be unable to both fund capital and adequately serve their local community and, therefore, will need to find a partner who can. We anticipate that the loss of the tax-exempt bond market will lead to further consolidation in the industry.

Let’s indulge in one last bit of speculation. What is the probability that Congress will pass legislation that eliminates tax-exempt financing? Sources in Washington tell us that it is premature to wager on any of the items put forth by the Budget Committee. And it should be noted that over the years the elimination of tax-exempt financing has been proposed on several occasions and never advanced in Congress. However, one well-informed source noted that as the tax and related legislation moves forward, there is likely to be significant horse-trading (especially in the House) to secure the necessary votes to pass the entire package. What happens during that horse-trading process is anybody’s guess. So the best advice to our hospital readership right now is to not take anything for granted. But be absolutely assured that the maintenance of tax-exempt financing is an essential strategic component for the successful future of America’s hospitals.

Pace of Downgrades Slowed in 2024: Five Key Takeaways

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https://www.kaufmanhall.com/insights/blog/pace-downgrades-slowed-2024-five-key-takeaways

Downgrades continued to outpace upgrades in 2024 although at a lower rate than in 2023. When combining the rating actions of the three rating agencies, the number of downgrades (95) declined while the number of upgrades (37) increased, compared to 116 and 33, respectively, in 2023. Many of the downgrades reflected ongoing expense pressure that exceeded revenue growth, even as volumes headed back to pre-pandemic levels and the use of contract labor declined. Other downgrades reflected outsized increases in debt to fund pivotal growth strategies. Most of the upgrades reflected mergers of lower-rated hospitals into higher-rated systems. Rating affirmations remained the majority rating action in 2024, as in prior years.

Key takeaways include:

  1. The ratio of downgrades to upgrades narrowed at Moody’s (2.0-to-1 in 2024 from 3.2-to-1 in 2023) and Fitch (1.5-to-1 from 3.5-to-1). S&P saw a wider spread in the ratio: 4.5-to-1 in 2024 from 3.8-to-1 in 2023.
  2. Downgrades reflected a wide swath of hospitals, from small independent providers to large regional systems. Large academic medical centers and children’s hospitals saw downgrades, even with exclusive tertiary services that provided differentiation with payers. Shared, recurring downgrade factors included weaker financial performance, payer mix shifts to more governmental and less commercial, and thinner reserves. Many of the downgrades were concentrated along the two coasts: California and the Pacific Northwest and New York and Pennsylvania. Many of the ratings were already in low or below investment grade categories.
  3. Multi-notch downgrades continued in 2024, ranging from two to four notch movements in one rating action. One of the hospitals that experienced a four-notch downgrade subsequently defaulted on an interest payment (Jackson Hospital & Clinics, AL). Multi-notch upgrades reflected mergers into higher-rated systems, the largest being a seven-notch upgrade of a small, single-site hospital into a 19-hospital system in the Midwest.
  4. Five hospitals experienced multiple rating actions in 2024, with rating committees convening not once but two and three times during the year. These were distressed credits whose financial performance and reserve levels dropped materially from quarter to quarter, a characteristic of high-yield or speculative rated borrowers.
  5. While some of the upgrades followed mergers, other upgrades reflected improved financial performance and stable or growing liquidity. Likewise, some of the upgraded hospitals began receiving new supplemental funds known as Direct Payment Programs (DPPs). Unlike other supplemental funds, DPPs are subject to annual federal and state approval, making their long-term reliability uncertain. Numerous types of providers saw upgrades—including academic medical centers, independent hospitals and regional health systems—and were located across the U.S. Most of the upgraded hospitals (excluding those involved in mergers) were already investment grade.

As in past years, rating affirmations represented the overwhelming majority of rating actions in 2024. This is welcome news for the industry as many hospitals and health systems will turn to the bond market to borrow for their capital projects. Investors’ view of the industry should be bolstered by the change in industry outlooks. S&P moved to Stable from Negative and Fitch moved to Neutral from Deteriorating in December 2024, joining Moody’s revision to Stable from Negative in 2023.

We expect rating affirmations will again be the majority rating action in 2025. However, even with the stability viewed by the agencies, we expect downgrades to outpace upgrades given a growing reliance on government payers, labor challenges and a competitive environment. Policy and funding changes will also cast uncertainty into the mix in 2025 and may cause credit deterioration in future years.

Downgrades Topple Upgrades: 5 Key Takeaways from Rating Activity in 2023

Posted on by • Posted in Bond Covenant Violations, Credit Downgrade, Credit Quality, Credit Rating Committee, Credit Rating Process, Credit Ratings, Credit Upgrade, Health System, Hospital, Hospital Industry, Labor Spend Management, Medicare, Medicare Advantage, Operating Expenses, Operating Income, Operating Margin, Operating Margin Drivers, Operating Metrics, Payor Mix • Leave a comment
https://www.kaufmanhall.com/insights/blog/5-key-takeaways-healthcare-rating-activity-2023?utm_source=mkto&utm_campaign=lisa-blog&utm_medium=em&utm_term=240124&mkt_tok=NjU0LUNOWS0yMjQAAAGQ2vVJyGwQD0qEoxeLrwDPY0slpcepOTHVq-56xKYVyfw5uMuWOoieiZx41BRE_QtWw7lvEk1Mf1uUJayukIw9peaC8OgZ1osd7EWbaLHcMGg0

As expected, 2023 saw a material increase in downgrades over 2022 while the number of upgrades declined from the prior year. Volume showed favorable growth for many hospitals during 2023 although some indicators remained below pre-pandemic levels. Other hospitals reported a payer mix shift toward more Medicare as the population continued to age and Medicare Advantage plans gained momentum at the expense of commercial revenues. Continued labor challenges drove expense growth, even with many organizations reporting a reduction in temporary labor, as permanent hires pressured salary and benefit expenses. Some of the downgrades reflected pronounced operating challenges that led to covenant violations while others were due to a material increase in leverage viewed to be too high for the rating category.

Figure1: Downgrades at Moody’s, S&P, and Fitch

Here are five key takeaways:

  1. The ratio of downgrades to upgrades reached a high level for all three rating agencies: Moody’s, 3.2-to-1; S&P: 3.8-to-1; and Fitch: 3.5-to-1. In 2022, the ratio crested just above 2.0-to-1 at the highest among the three firms.
  2. Downgrades covered a wide swath of hospitals, ranging from single-site general acute care facilities to academic medical centers as well as large regional and multistate systems. Many of the hospital downgrades were concentrated in New York, Pennsylvania, Ohio, and Washington. All rating categories saw downgrades, although the majority were clustered in the Baa/BBB and lower categories.
  3. Multi-notch downgrades were mainly relegated to ratings that were already deep into speculative grade. Multi-notch upgrades were due to mergers or acquisitions where the debt was guaranteed by or added to the legal borrowing group of the higher rated system.
  4. Upgrades reflected fundamental improvement in financial performance and debt service coverage along with strengthening balance sheet indicators. Like the downgraded organizations, upgraded hospitals and health systems ranged from single-site hospitals to expansive, super-regional systems. Some of the upgrades reflected mergers into higher-rated systems.
  5. The wide span between downgrades to upgrades in 2023 would suggest that the credit gap between highly rated hospitals (say, the “A” or “Aa/AA” category) compared to “Baa/BBB” and speculative grade is widening. That said, given that rating affirmations remain the predominant rating activity annually, the rating agencies reported only a subtle shift in the overall distribution of ratings since the beginning of the pandemic in their panel discussion at Kaufman Hall’s October 2023 Healthcare Leadership Conference.

One person’s prediction for 2024?

It’s a safe bet that downgrades will outpace upgrades given the persistent challenges, although the ratio may narrow if the improvement in current performance holds. That said, the rating agencies are maintaining mixed views for 2024. S&P and Fitch are sticking with negative and deteriorating outlooks, respectively, while Moody’s has revised its outlook to stable, anticipating that the rough times of 2022 are behind us.

All three rating agencies predict that we are not out of the woods yet when it comes to covenant challenges, especially in the lower rating categories or for those organizations that report a second year of covenant violations.

California system’s 10.2% operating margin bucks national trend

Posted on by • Posted in Credit Quality, Credit Ratings, Credit Upgrade, Financial Reserves, Financial Stewardship, Financial Strength, Financial Viability, Health System, Hospital, Hospital Industry, Labor Spend Management, Nurse Agency Staffing, Nurse Retention, Nurses Compensation, Operating Expense Reduction, Operating Expenses, Operating Income, Operating Margin, Operating Metrics, Operating Performance, Operating Revenue, Retention, Talent Management • Leave a comment
https://www.beckershospitalreview.com/finance/california-system-s-10-2-operating-margin-bucks-national-trend.html?utm_campaign=bhr&utm_source=website&utm_content=latestarticles

Mountain View, Calif.-based El Camino Health ended the first quarter with an impressive operating margin of 10.2 percent when many health systems saw their margins hover above zero or fall into the red. The system’s revenue for the quarter totaled $131,290. 

For the nine months ended March 31, the two-hospital system posted an operating gain of $141.4 million on revenue of just over $1 billion. 

However, like most health systems, El Camino’s expenses are substantially higher than the same period last year, increasing 10.6 percent year over year for the nine months ending March 31, 2023, to $881.9 million. 

The system is making a conscious effort to march down labor costs while also placing a significant emphasis on retention. In June, El Camino agreed a deal to increase pay for nurses by 16 percent over three years.

“Like nearly all hospitals, our nursing staff comprises the largest part of our workforce. With the recruitment of a single nurse estimated to be nearly $60,000, our primary strategy to reduce labor costs is to focus on decreasing turnover,” El Camino CEO Dan Woods told Becker’s.

“Our turnover rate for nurses is just about 8 percent while the turnover rate nationally is still running at 22 percent.”

In March, the system also received a credit rating upgrade from Moody’s, which noted the system’s “superlative cash metrics and operating performance.” Fitch Ratings also revised El Camino’s outlook to positive in February, noting that the system has a history of generating double-digit operating EBITDA margins, driven by a solid market position that features strong demographics and a very healthy payer mix.

4 health systems with recent credit rating upgrades

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https://www.beckershospitalreview.com/finance/4-health-systems-with-recent-credit-rating-upgrades.html?utm_medium=email&utm_content=newsletter

Here are four health systems that recently had their credit rating upgraded by Fitch Ratings, Moody’s Investors Service or S&P Global Ratings:

1. Cooper University Health Care received upgrades from both S&P and Moody’s. S&P upgraded the Camden, N.J.-based system from “BBB+” to “A-,” praising Cooper for its focus on cost containment, revenue improvement, expanding market share and developing key services to gain more tertiary referrals and limit outpatient migration to Philadelphia academic medical centers. 

Moody’s raised the system’s bond ratings from “Baa1” to “A3” and said it expects Cooper’s operating margins will be maintained through execution of its performance improvement plan and strong growth in key service lines. 

2. Loma Linda (Calif.) University Medical Center’s rating was raised to “BB+” from “BB” by Fitch. “The upgrade … incorporates LLUMC’s major new hospital, which is now open, and the system has been operating in their new environment for more than one year, removing a considerable risk factor,” Fitch said in a report. 

3. Mercy Health’s credit rating was upgraded from “A-” to “A” by Fitch. The rating agency said the Rockford, Ill.-based system’s operating profile is expected to remain strong in the longer term. 

4. Orlando (Fla.) Health’s rating was upgraded to “AA-” from “A+” by Fitch. The ratings agency said in a report the bump “reflects the continued strength of OHI’s operating performance, growth in unrestricted liquidity and excellent market position in a demographically favorable market.”

Cooper University Health Care credit rating up to A-, its highest ever

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https://www.beckershospitalreview.com/white-papers/cooper-university-health-care-credit-rating-up-to-a-its-highest-ever.html?utm_medium=email&utm_content=newsletter

S&P Global Ratings raised Cooper University Health Care’s credit rating from “BBB+” to “A-“, the highest rating in the Camden, N.J.-based system’s 135-year history, roj-nj.com reported Nov. 28.

The rating is for bonds issued by Camden County Improvement Authority. S&P praised Cooper for its focus on cost containment, revenue improvement, expanding market share and developing key services to gain more tertiary referrals and limit outpatient migration to Philadelphia academic medical centers, according to the report.

“Today’s credit rating upgrade is validation of Cooper’s financial strength, our prudent growth strategies and the tremendous work by our dedicated team members who tirelessly serve our patients, their families and each other to produce our current and future success,” co-CEO Kevin O’Dowd said.

Cooper is expected to begin construction on a $2 billion expansion of its Camden, N.J., campus in 2023.