Death and disease know no recession. Hospitals do.
Richard Ciccarone, chief research officer at McDonnell Investment Management LLC, believes concerns about some hospitals in this recession have punished an entire sector of municipal bonds.
The upshot is investors have an opportunity to buy debt issued by safe, strong hospitals — with a steady influx of patients — at attractive yields.
Many state- or city-run hospitals issue tax-exempt bonds to finance construction or improvements. The coupons and principal on the bonds are secured by revenue from patients, mainly through Medicare, Medicaid and private insurers.
Americans spent $696.5 billion at all hospitals in 2007, according to the Centers for Medicare and Medicaid Services.
According to Standard & Poor’s, hospitals have 3,030 bond issues outstanding with a collective market value of $54.49 billion.
Ciccarone doesn’t mean to dismiss the risks of owning bonds in this sector. The risks are substantial, he said.
Recovery rates in the event of default are lower than for many other types of tax-exempt debt, Ciccarone pointed out. And the concerns about Medicaid, competition, the economy, the growing ranks of the uninsured, and uncollectible debt from patients that have driven yields higher are real, he said.
Forum Health, a three-hospital system in Youngstown, Ohio, filed for Chapter 11 bankruptcy protection last month. Ciccarone said more will likely follow.
His point is many strong hospitals’ bonds have been tossed onto the scrap heap. By salvaging high-quality hospitals from that heap, Ciccarone said, investors can find strong credits with plump yields.
The yield on the S&P hospitals index has skyrocketed more than a percentage point in the past year, from 5.34% at the end of March 2008 to 6.43% now.
The yield swelled to 7.13% in December.
“Hospitals across the board have been penalized,” Ciccarone said. “Many good hospitals are being lost when you shade the whole sector negatively. ... It’s not a sector for the faint-hearted, but there are opportunities.”
Ciccarone said investors have to ferret out the strong from the weak the old-fashioned way — one at a time.
On the credit side, investors should look for several metrics showing the financial strength and liquidity of the hospital.
The most commonly used gauge is the debt-service coverage ratio, which reflects a hospital’s ability to pay its debt using cash generated from operating income. Ciccarone said a debt-service coverage better than 3 is safe.
Another metric is days cash on hand, which shows how many days a hospital could operate using available cash.
While these metrics are deteriorating at many hospitals, Ciccarone said for the sector as a whole they were at an all-time high in 2007 and remain historically stable.
Based on a sample of hospitals that have reported figures for 2008, Ciccarone said median debt-service coverage is 3.5 times, which means a hospital’s operating income is 3.5 times its debt costs for the year.
Twenty years ago — which was a low point in the sector — median debt-service coverage was 2.6 times, he said.
“That’s a long way to go,” he said. “That’s a suggestion that a lot of hospitals are poised to come through this economic crisis without posing a threat to debt-service protection.”
The median days cash on hand for this sample is 150. That is more than twice the median days cash on hand in the late 1980s, Ciccarone said.
About a third of the hospitals tracked have cash on hand covering more than 253 days of expenses, he said.
“Many hospitals built up extremely large cash reserves just before the crisis,” he said.
Many hospitals not in the bottom tier boast strong cash flow, liquidity, and other indicators Ciccarone considers important. He believes fewer than a quarter of hospitals are weak. Yet much of the sector trades at a fat spread to the highest-grade munis.
Single-A rated hospitals are trading at yields 190 basis points higher than triple-A rated munis, according to Municipal Market Data. As recently as last July, the spread was less than 100 basis points.
“There’s some strength going into this crisis, but the weak hospitals are getting all the attention and accounting for most of the spread,” he said.
Ciccarone says he’s not at liberty to talk about individual bonds. He did say he found a hospital in Florida with a double-A minus rating, debt-service coverage of 5.89 times, a profit margin of 9%, and 247 days cash on hand as of last year.
That hospital’s bonds maturing in 2014 yield 220 basis points more than triple-A rated munis of the same maturity, he said. Last year at this time, the spread was 80 basis points, he said.
Another example is a double-A-minus rated hospital in California with 7.22 times debt-service coverage and 137 days cash on hand with bonds maturing in 2022 yielding 160 basis points more than triple-A munis.
These are the types of opportunities Ciccarone is looking for: strong credits with stable cash flow trading at wide spreads.
He believes the best value is in the single-A rated tier. Much weaker than that means fishing through marginal credits; stronger means sacrificing yield.
“It’s when you get into the A-rateds that you find the most opportunity,” Ciccarone said.
