Why Healthcare Bond Investors Are Looking Past an Obamacare Repeal

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While health care bonds aren't immune to future ailments stemming from the repeal of Obamacare, members of the municipal buyside community say they remain active in the sector.

They're investing in the larger, stronger systems until there is more clarity on the fate of the nation's health care program.

Their reaction to a possible repeal, which is picking up steam on Capitol Hill, ranged from cautious to opportunistic as President-elect Trump and lawmakers say they plan to transition to a new health care program.

"We have not eliminated healthcare from our portfolios because it remains an important sector of the municipal market," Jonathan Law, portfolio manager at investment and financial services firm Advisors Asset Management said in an interview on Thursday. "Adequate exposure to healthcare names – not too little and certainly not too much – ensures that we can build well-balanced and diversified portfolios for our clients."

Portfolio managers and analysts said they probably have time on their side as the ACA insurance coverage is expected to exist this year and next, before any real impact to Americans or investors in the municipal health care sector.

Voters should not expect to see any changes to their health insurance plans under the ACA for two years after the law is repealed, a senior official on Donald Trump's White House transition team told MSNBC on Thursday.

"Immediately, what we're saying is we're not going to pull the rug out from under anyone. There's not going to be any changes in 2017. There's not going to be changes in 2018," Rep. Chris Collins (R-NY), the transition team's congressional liaison, said in an interview on the cable network.

Some portfolio managers expect the spreads between yields on health care bonds and a triple-A benchmark to continue a trend of widening, which surfaced after the Presidential election. Others expect increased uncertainty as lengthy negotiations unfold in Washington.

Law said he has been pro-health care sector prior to the ACA becoming law in 2010 and will most likely stand pat after its repeal.

"Since no one knows how the ACA repeal and replacement will play out, the safest way to approach healthcare credit is through bottom-up fundamental analysis," Law said.

"This approach looks beyond the broad healthcare sector and economic conditions and instead focuses on selecting credit based on the individual attributes of a company."

The ACA was enacted nearly seven years ago with virtually no Republican support to reform U.S. health care and improve the affordability, quality, and availability of health insurance.

The 2,000-page statute included new cost-cutting measures, rules, and regulations for both public and private health insurance companies and the health care industry.

Some shared Law's view that the repeal of the ACA is not an epidemic to be feared, but a change that could bring with it a replacement program with its own benefits and opportunities.

Clarity Needed
"We are not in favor of materially adjusting our exposure to the sector in the absence of some additional clarity on the outlook and details surrounding the repeal of Obamacare and the program that will be designed to replace it," Jeff MacDonald, director of fixed income strategy at Fiduciary Trust Co. told The Bond Buyer on Thursday.

In October, the portfolio manager was adding exposure to and finding value in the health care sector and plans to continue to be active pending further movement on the repeal.

"Within the healthcare sector we have tried to focus on higher quality, large hospital systems with a diverse geographic patient base and solid ability to control costs across the system," MacDonald said. "We view single hospital or small concentrated systems as likely to carry a higher degree of credit risk, especially in the wake of the Obamacare repeal, and have largely avoided these exposures in client portfolios."

A full repeal of the ACA may cut hospital revenue by close to $400 billion over the next 10 years, according to a report released last month by the Federation of American Hospitals and the American Hospital Association.

The repeal would put pressure on state and local budgets, as well as healthcare bond ratings in a sector that has issued almost $154 billion of bonds from 2010 to 2015.

There are currently about $200 billion in outstanding tax-exempt hospital bonds, according to Ziegler.

Municipal bond mutual funds hold a significant portion of outstanding health care debt, according to Morningstar Inc.

Out of the universe of 586 municipal bond funds, 568 funds, or 97%, have some health care exposure ranging from 0.18% to 34%, representing approximately $84.23 billion in health care debt as of Jan. 5, according to the fund tracker.

There are only 18 municipal bond funds with zero exposure to the health sector, according to Morningstar.

The Fidelity Maryland Municipal Income Fund [Ticker: SMDMX] has the largest percentage of health care exposure, holding 34.71%, or $75.72 million, according to Morningstar. The fund had total net assets of $213.60 million as of Dec. 30, the fund tracker said.

Bonds from the Maryland State Health & Higher Educational Facilities Authority lead the top five holdings of the Fidelity fund, according to a snapshot on its own website at https://fundresearch.fidelity.com.

Big Exposure
One of the largest holders of health care bonds by volume is Vanguard's Intermediate Term Tax-Exempt Fund [Ticker:VWITX], which currently holds approximately $4.98 billion. The holdings represent 9.31% of the fund, which had total net assets of $49.37 billion, as of Dec. 31, according to Morningstar data.

The second highest owner is American Funds' Tax-Exempt Bond Fund [Ticker: AFTEX], which has exposure to $3 billion in health care debt, Morningstar said. That accounts for 21.22% of its fund, which totaled $13.18 billion fund as of Jan. 4, according to the fund tracker.

American Funds is followed by an additional Vanguard fund – the Vanguard Limited Term Tax-Exempt Fund [Ticker: VMLTX], which holds $2.384 billion, representing 9.85% of its total net assets, which amounted to $21.89 billion as of Dec. 31, according to Morningstar.

Continued healthy ownership by the municipal buyside community could depend on the future of Obamacare – or its successor plan, portfolio managers and analysts said.

Some acknowledged the improvements of the health care sector – and available opportunities in municipal health care and hospital credits – under the ACA and said they will participate in the sector as usual.

"It represented a modest positive for hospitals and healthcare providers as it reduced the number of uninsured patients in the population," MacDonald said.

"The likely repeal of the ACA introduces a great deal of uncertainty into the healthcare sector, certainly on the repeal side, but probably more-so on the replace side," he continued.

The only other significant reversal by Congress of a major health-care policy — the expansion of Medicare to include catastrophic coverage — took place in 1989 before the benefit took effect.

"Republican lawmakers are obviously aware that eliminating health insurance for the roughly 20 million Americans currently covered by the ACA would be devastating for patients as well as hospitals and healthcare providers," MacDonald said. "In light of this, we see an upcoming repeal of the ACA in fairly short order with a multi-year transition plan put in place until a formal replacement can be worked out in Congress."

Until then, MacDonald said details on what the transition or replacement will look like are scant, and that adds to the uncertainty of the forward outlook.

Others said they expect major changes again to the landscape of the health care sector after a successor plan arrives.

"Last year, we saw a few mergers take place across the sector so we wouldn't be surprised to see additional consolidation across the industry as hospital systems aim to further reduce overhead costs and increase their leverage with insurers," Law said.

"If these trends play out, we should see spreads tightening among the larger non-profit systems, while the stand-alone entities face additional weakened operations and credit deterioration," he added.

Standard & Poor's in 2015 said the Affordable Care Act helped boost the non-profit health care sector out of a year-long slump – enough to revise its outlook to stable from negative in light of the improvements.

The agency said it had a significant effect on volume, payor mix, and on reduction in uncompensated care, and in the sector's overall performance, according to analyst Martin Arrick in September 2015 after a rating agency webcast.

Moody's Investors Service in August 2015 also revised its sector outlook to stable from negative, and Fitch Ratings, said surprising gains were expected to continue.

Widening Spreads
Alan Schankel, at Janney Montgomery Inc., said investors may still find some value in the sector if they make careful security selections going forward – but there is reason to be wary.

"Uncertainty is the watchword for non-profit healthcare in 2017," he told The Bond Buyer on Wednesday.

In terms of the impact on the muni market, Schankel said spreads on healthcare bonds have widened since the presidential election – and he expects spreads to widen further as the debate is waged in Washington.

Double-A-rated general market health care spreads on 10-year paper versus the generic 10-year, triple-A general obligation scale have widened to 44 basis points as of Jan. 5, from 29 basis points at the start of the fourth quarter on Oct. 3, 2016 – just ahead of the Presidential election, according to data from Thomson Reuters and Municipal Market Data provided by Schankel.

Spreads had narrowed to as tight as 26 basis points on several days in May 2016, and were widest at 47 basis points over a few weeks in February and March of 2016.

Back in October 2015, Schankel suggested large, non-profit health care issuers were a good buy since there was more demand for those systems, boosted by growth in the insured population.

He is still recommending the sector, suggesting investors take advantage of future spread widening by investing in stronger systems rated Aa3 or better – and those with more than $5 billion in annual revenue.

Opportunity
He shared MacDonald's view that there is opportunity to invest while the Trump administration and Congress square off.

"I think the larger, well-rated systems will generally be in the best position to react to and navigate the impact of upcoming changes," he added.

"In a worst case scenario, Congress and the new President will go back to square one, eliminating Medicaid expansion and the subsidies to be used on health exchanges. That would mean 20 million – or more – fewer consumers with insurance, and fewer paying customers for healthcare providers.

"The revenue reduction would certainly stress hospital profits and losses, and balance sheet data – and perhaps generate downgrades," Shankel said.

But, Schankel said, that worst case scenario is "very unlikely."

"Taking health insurance away from 20 million people could prove politically dangerous," he said. "It is more probable that the 'replace' part of repeal and replace will retain many if not most of newly insured, although coverage may be reduced.

"The other important point is that the replace part will take time – which is a negative due to continuing uncertainty, but a positive in that the well-managed systems will have time to react and make changes as appropriate."

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