CHICAGO — The wave of consolidation sweeping through the non-profit health care sector sparked a surprising trend of upgrades over downgrades during the third quarter, a trend that could continue throughout the year, Moody's Investors Service said in a report out Wednesday.

Moody's upgraded 12 providers and downgraded seven during the third quarter. Half of the upgrades during the period, and 27% for the year so far, are due to mergers. Excluding those upgrades, there would have been an equal number of six upgrades and six downgrades, Moody's said.

So far this year, Moody's has upgraded 33 providers with a total of $8.2 billion of debt and downgraded 30 with a total of $5.2 billion. Taking out the consolidation-driven upgrades, there were only 24 positive rating actions compared to 29 downgrades.

"While we had expected that downgrades would outpace upgrades for the total year ... we will likely see this expectation unfulfilled due to consolidation activity and subsequent upgrades," analyst Carrie Sheffield wrote in "US Not-For-Profit Healthcare Quarterly Ratings: Driven by M&A Activity, Upgrades Surpass Downgrades in Third Quarter 2012."

"However, in keeping with our negative outlook on the not-for-profit health care sector, we continue to expect to see pressures on revenues from multiple sources to persist due to the continued slow economic recovery, increasing pressure on state budgets and a large and growing federal deficit," she wrote.

The merger trend is generally considered positive for the sector, and many of the merging hospitals can see upgrades, especially smaller ones, which can often see "relatively dramatic upward rating movement," Moody's said.

But a partnership can spark a downgrade as well, typically when a stronger credit acquires a very distressed one. Moody's hit Mass.-based Lowell General Hospital with a downgrade to Baa2 from Baa1 after the provider acquired then-junk-rated Saints Memorial Medical Center. Saints Memorial, however, won an upgrade into investment grade territory from the deal.

Smaller credits tend to be downgraded more often than larger ones, so that the volume of upgraded debt tends to be larger than the volume of downgraded debt, even if downgrades outpace upgrades. For the third quarter of 2012, nearly three-quarters of the seven downgraded providers had total operating revenue of $500 million or less compared to 42% of the 12 upgraded providers.

Only one downgraded provider fell to junk-bond status: Saint Peter's University Hospital in New Jersey dropped to Ba1 from Baa3 due to a decline in volumes and increased competition.

As usual, the majority of the ratings actions were affirmations, which totaled 80% of all ratings actions during the third quarter.

Separately, Bank of America Merrill Lynch in a recent muni commentary identified another trend in the non-profit health care sector: increased scrutiny of tax-exempt rules by the IRS. The bank names three developments that affect the market, including the IRS' decision to postpone until Dec. 5 from Oct. 25 a hearing on its proposed new rule on requirements for tax-exempt hospitals, and the agency's announcement that it is reviewing the community benefit activities of 3,377 tax-exempt hospitals. Third, the IRS' Exempt Organization division recently announced it is reviewing 2,000 parent organizations of hospitals for compliance with tax-exemption rules.

The first two actions are part of the IRS' ongoing review of non-profit hospitals, but the review of parent organizations "is aimed in a different direction, at a larger universe of tax-exempt entities," the report said.

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