Hospitals are doling out a dose of bitter medicine in the form of riskier bonds.
Investors hungry for higher yields in an environment of near-zero interest rates are clamoring for the municipal bonds issued by hospitals and other health-care facilities. Borrowers are capitalizing on this rising demand by dispensing with standard investor protections on their bonds.
While less protection is a pill many investors are eagerly swallowing, some are raising alarm bells and staying away from hospital bonds. This debt has long been considered risky when compared with other municipal bonds, but now the debt is even riskier, they say.
“It’s a worrisome trend in my mind…but there’s just such demand for yield that issuers can get away with it,” said Kathy Bramlage, director at Treasury Partners, a unit of financial-advisory firm HighTower Advisors. She said her firm, which has about $ 8 billion of fixed-income assets under management, avoids buying hospital debt.
Although it is unclear exactly how many issuers have dropped protections, investors and analysts say the practice has gained traction within various pockets of the muni-bond market. Health care is drawing particular attention due to a flurry of recent deals that lacked the cushions against default that investors have come to expect.
Hospital bonds have a default rate that is about 10 times that of taxpayer-backed state and local government debt, if instances where borrowers dip into reserves or violate bond contracts are included, according to research advisory firm Municipal Market Advisors. Also of concern is the coming overhaul to the U.S. health-care system, which is expected to introduce more uncertainty into the revenue and profit projections that help bondholders judge the likelihood of getting repaid.
But with the risk comes the relatively high yields that attract hordes of investors seeking better returns. Hospital munis returned 8% this year through the start of August, according to a Bank of America Merrill Lynch index, against 5.6% for the broader muni-bond market.
The disappearance of certain protections is a side-effect of investor demand outpacing supply for health-care bonds, said Robert Amodeo, portfolio manager at Western Asset Management, which oversees $ 30 billion of muni assets. “It’s part of the good, old-fashioned credit cycle, and issuers are trying to take advantage of that,” he said.
But some investors are turning away, saying that without certain protections, known as “covenants,” the risk of putting money in the debt isn’t worth the higher yields. Mr. Amodeo said he is buying into fewer hospital-bond sales because of weakening protections.
The latest bond offering from Kennedy Health System, with 621 beds across three hospitals in New Jersey, is one example of those lessened protections. Last month, the hospital chain sold $ 66 million in bonds to refinance debt issued about a decade ago. Bondholders continued to get first dibs on revenues, but additional cover was dropped: mortgages on the hospitals and a reserve fund that held money to repay the debt in case revenues fell short.
Even without the covenants, investors’ bids for some parts of Kennedy’s offering far outnumbered the amount of debt being sold, said Chief Financial Officer Gary Terrinoni. Given the appetite, he said he didn’t think the protections were necessary.
Similarly, University Hospitals in Cleveland, Ohio, sold $ 184 million in debt in May without a reserve fund, even though it had just 118 days’ cash on hand at the end of last year, below the median level for hospitals with a similar investment-grade credit rating, according to a Moody’s report. A reserve fund was written into the 2009 bonds it refinanced in the May deal.
“If the market doesn’t require that feature, it’s not an advantage for us to provide it,” said Brad Bond, University Hospitals vice president of treasury. University Hospitals had “no challenge at all” selling the bonds, he said.
To be sure, not all hospital bonds are worth skipping, but it is important to be selective, some investors say. Richard Ciccarone, chief research officer at McDonnell Investment Management, said his firm still buys hospital bonds but evaluates each one based on the hospital’s finances as well as the local economy.
“There is some essentiality to health care, and the question is, who will be the survivors” of the health-care overhaul and the tough economy, said Mr. Ciccarone, whose firm oversees roughly $ 8 billion in muni assets.
But there are broader indications that investors are cooling to health-care bonds. One such sign is a recent widening of the yield gap between these bonds and a broad index of highly rated municipal bonds.
Mid-investment-grade hospital bonds maturing in 10 years now yield 1.34 percentage points more, compared to a gap of 1.23 percentage points in late April, a three-year low, according to Thomson Reuters Municipal Market Data. The average gap is 1.56 percentage points over the past three years.
Michael Walls, a portfolio manager who oversees $ 2.2 billion in two municipal-bond funds at asset manager Waddell & Reed Inc., said he hasn’t bought a hospital bond “in some time,” adding that most of the health-care bonds in his funds were issued in 2008 and 2009, when lessons of the financial crisis were still fresh.
“It’s now much more of an issuer’s market,” Mr. Walls said.
Write to Kelly Nolan at email@example.com
A version of this article appeared August 10, 2012, on page C4 in the U.S. edition of The Wall Street Journal, with the headline: Hospitals’ Debt Gets a Checkup.