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Fixed-Income Insights

Financial pressures, competitive threats, and the need for geographic diversity are some of the factors behind the trend.

The U.S. hospital sector is an important, and active, corner of the municipal-bond market, with issuance of fixed-rate bonds totaling $23.8 billion in 2018 (through November 13).* But the industry is experiencing a rapid pace of merger and acquisition activity as hospitals face an increasingly demanding operating environment. In the first nine months of 2018, 23 pairs of hospitals completed or signed agreements to merge, compared with 25 in the same period a year ago, according to a Debtwire Municipals analysis.

 

U.S. Nonprofit Hospital Mergers Have Continued at a Strong Pace in 2018
Data as of September 30, 2018

Source: Debtwire.

 

Within the flurry of M&A activity, we can identify various drivers behind hospital combinations. These range from struggling hospitals’ need to remain viable, large health systems’ desire to remain competitive, the need to diversify geographically, and competitive threats from nontraditional players.

It is becoming increasingly difficult for hospitals to survive on a stand-alone basis, driving many such facilities to seek out partnerships. Expense growth is outpacing revenue growth, driven by increases in supply costs, a tight labor market, and the need to employ physicians and invest in technology to remain competitive. Revenue growth, on the other hand, is being stifled by lower reimbursement from both government and commercial payers and an industry-wide shift to outpatient settings for care. As a result of such pressures, reports from major rating agencies showed that 2017 was the second consecutive year of significantly weaker operating margins for the sector.

Strengthening Credit
Merging with a stronger partner can drive significant improvement in smaller hospital’s credit quality. The University of Pennsylvania Health System’s acquisition of Princeton Healthcare System in January 2018 resulted in Moody’s upgrading Princeton’s debt to Aa3 from Baa2. Likewise, Northwestern Memorial HealthCare’s acquisition of Centegra Health System in September 2018 drove an upgrade of Centegra’s BB+ rating to the AA+ by S&P. While Princeton Healthcare boasted strong financials and a leading market position, the merger with a larger partner fortified the hospital against future challenges. Centegra’s decision to merge, on the other hand, was driven by weak operations and a competitive environment.

Whether to achieve critical mass, add scale, or as a defensive measure, there are several reasons why large health systems decide to acquire smaller hospitals. After welcoming Southampton Hospital in 2017, Stony Brook University Hospital is now seeking to acquire a second facility in its region, Eastern Long Island Hospital, in order to achieve critical mass in that service area. Mercy Health and Bon Secours Health System, both large, multi-state Catholic health systems with ‘A’ ratings, closed their merger in September 2018, creating the fifth largest Catholic health system in the nation and providing opportunities for increased economies of scale.

WellSpan Health’s plan to acquire Summit Health comes in the midst of a flurry of acquisitions by its competitors in south-central Pennsylvania including Geisinger Health, the University of Pittsburgh Medical Center, and the University of Pennsylvania Health System, all intent on growing their footprint.  

Geographic Footprints
A further driver of mergers is enhanced geographic diversification. Partners Healthcare System, an integrated delivery system in Massachusetts, has recently ventured into neighboring states, starting with its acquisition of Dover, N.H.-based Wentworth-Douglass Hospital in 2017. In 2018, Partners signed affiliation agreements with both Northern Light Health in Maine and Providence, R.I.-based Care New England.

Similarly, the Cleveland Clinic has been diversifying its holdings, historically concentrated in the Cleveland service area, most recently with its plan to acquire Martin Memorial Medical Center in Stuart, Fla.

The industry is also experiencing increasing competition from nontraditional players such as pharmaceutical, insurance, home health, and hospice companies. In October 2018, Humana announced plans to acquire Kindred Healthcare, a post-acute provider operating long-term acute-care hospitals and providing rehabilitation services, in an attempt to gain more control over health care delivery and keep care out of more expensive hospital settings. Likewise, CVS Health’s potential acquisition of Aetna is an attempt to treat more patients at upgraded drugstores and keep them out of emergency care facilities. To defend against such competitive threats, hospitals are themselves attempting to become more vertically integrated. One recent example is ProMedica’s 2018 acquisition of HCR ManorCare, a senior living, homecare, and hospice business.

Amid the growing challenges faced by the acute care hospital sector, winners in the space will be dominated by large integrated health systems serving a large number of patients, rendering them indispensable to insurers and the communities they serve. However, small hospitals that are essential providers of key services with a dominant market share in their communities may also present attractive investment opportunities for municipal-bond portfolios, especially given their desirability as takeover targets for larger health systems.

 

*Source: “Hospital Recap,” Wells Fargo Securities, November 13, 2018.

 

IMPORTANT INFORMATION

This commentary may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

This material is provided for general and educational purposes only. It is not intended as an offer or solicitation for the purchase or sale of any financial instrument, or any Lord Abbett product or strategy. References to specific asset classes and financial markets are for illustrative purposes only and are not intended to be, and should not be interpreted as, recommendations or investment advice.

References to specific securities and issuers are for illustrative purposes only and are not intended and should not be interpreted as recommendations to purchase or sell such securities. The securities referenced may or may not be held in portfolios managed by Lord Abbett and, if such securities are held, no representation is being made that such securities will continue to be held. This is not a representation of any securities Lord Abbett purchased or would have purchased or that an investment in any securities of such issuers would be profitable.

A Note about Risk: The value of an investment in fixed-income securities will change as interest rates fluctuate and in response to market movements. As interest rates fall, the prices of debt securities tend to rise. As rates rise, prices tend to fall. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The municipal bond market may be impacted by unfavorable legislative or political developments and adverse changes in the financial conditions of state and municipal issuers or the federal government in case it provides financial support to the municipality. Income from the municipal bonds held could be declared taxable because of changes in tax laws. Certain sectors of the municipal bond market have special risks that can affect them more significantly than the market as a whole. Because many municipal instruments are issued to finance similar projects, conditions in these industries can significantly affect an investment. Income from municipal bonds may be subject to the alternative minimum tax. Federal, state and local taxes may apply. Investments in Puerto Rico and other U.S. territories, commonwealths, and possessions may be affected by local, state, and regional factors. These may include, for example, economic or political developments, erosion of the tax base, and the possibility of credit problems.

The information provided is not directed at any investor or category of investors and is provided solely as general information about Lord Abbett’s products and services and to otherwise provide general investment education. None of the information provided should be regarded as a suggestion to engage in or refrain from any investment-related course of action as neither Lord Abbett nor its affiliates are undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity. If you are an individual retirement investor, contact your financial advisor or other fiduciary about whether any given investment idea, strategy, product or service may be appropriate for your circumstances.

The opinions in this commentary are as of the date of publication, are subject to change based on subsequent developments, and may not reflect the views of the firm as a whole. The material is not intended to be relied upon as a forecast, research, or investment advice, is not a recommendation or offer to buy or sell any securities or to adopt any investment strategy, and is not intended to predict or depict the performance of any investment. Readers should not assume that investments in companies, securities, sectors, and/or markets described were or will be profitable. Investing involves risk, including possible loss of principal. This document is prepared based on the information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information. Investors should consult with a financial advisor prior to making an investment decision.

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