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Municipal Bonds: Bullish Signs for the Hospital Sector
Insight • June 14, 2023
3 min. Read

Municipal Bonds: Bullish Signs for the Hospital Sector

Financial pressures on hospitals are easing after a challenging 2022, presenting an opportunity for muni-bond investors. 
In Brief
  • While general obligation bonds receive most of the headlines, revenue bonds represent a much larger portion of the municipal bond market.
  • The hospital sector is a large slice of the revenue-bond market and represents 13% of the overall muni market, as represented by the Bloomberg Municipal Bond Index.
  • Hospital muni bonds typically provide more yield than other areas in the municipal-bond market, so the sector can deliver attractive long-term returns when performing well.
  • Based upon our positive credit outlook and the sector’s relatively higher yields, we are bullish about the outlook for the performance of the hospital sector for the remainder of 2023.

Despite negative sector outlooks issued by credit-rating agencies and unfavorable narratives in the media, Lord Abbett is optimistic that the hospital sector will turn around during the remaining months of 2023. Recent rating downgrades were in response to financial results for 2022, one of the worst years on record for hospitals, and we expect several factors to drive improved margins in 2023. Because of the market reaction to challenges faced by hospitals in 2022, we feel there will be opportunity in the sector, with the caveat that credit selection will take on an even more important role.

Market Sentiment on the Sector Is Backward-Looking

In fiscal 2022, increased revenues from growing patient volumes were overshadowed by unprecedented growth in expenses related to the cost of supplies and clinical staff, leading to operating deficits for most hospitals. In addition, significant investment losses eroded hospitals’ liquidity cushions. Combined, these factors drove an increased incidence of covenant violations, rating downgrades, and negative sentiment among muni investors. 

Several Factors Point to a Stronger Fiscal 2023 for Hospitals

We anticipate stronger margins for U.S. hospitals in fiscal 2023, driven by continued growth in revenues and deceleration in expense growth. Patient volumes, especially on the outpatient side, should continue to grow for most hospitals, and we expect reimbursement-rate adjustments to drive revenue growth. A slowdown in labor cost increases—the largest expense line for the industry—should be driven by a reduced reliance on agency staff and a normalization in hourly rate increases as the labor market imbalance eases.

Further, health systems embarked on a combination of strategies in 2021 and 2022 to drive long-term operational improvement. We expect to see the benefits of these initiatives this year. These include:

  • Enhancing revenue generation and improving expense management
  • Discontinuing unprofitable service lines
  • Broadening labor-recruitment channels
  • Investing in outpatient strategies
  • Joint ventures with technology and supply-chain companies
  • Deepening clinical affiliations

Early Signs of Improvement

Recent financial indicators support our positive prognosis. We began to see margin improvement in the last quarter of 2022, continuing into the first quarter of 2023. A Kaufman Hall survey of 900 hospitals indicates that the median hospital operating margin improved every month during 2022, finally turning positive in December 2022. The survey also concludes that median contract labor rates declined to $126 per hour in December 2022 from $200 per hour in the first quarter of 2022. Non-labor costs (supplies, drugs, and purchased services) have also been trending downward. 

Credit Selection Will Be Important

Because of the fragmented nature of the sector, security selection for hospital municipal bonds is key. Through our credit research process, we identify key markets and hospitals when formulating a credit opinion. Additionally, due to the breadth of our research capabilities, we are able to analyze the full opportunity set within the space, across geographies and credit quality. Labor challenges and volume recovery will be uneven, and weak performers in competitive markets will likely see a continued decline in market share.

To inform our investment decisions, we focus on financial indicators as well as other key elements. Overall, we typically favor hospitals with the following characteristics:   

  • Geographic diversification 
  • Dominant market shares in key service lines
  • Strong cash positions
  • Significant investments in outpatient growth strategies
  • Improvement plans underway to grow the workforce 

In recent years, credit-quality changes to specific issuers had a limited impact on relative performance due to market factors, including rising rates across the entire market and, in 2020 and 2021, hospitals’ receipt of significant COVID-19 stimulus funds. Going forward, we can expect further widening in the range of credit-specific fundamentals in the hospital sector and believe that credit selection will take on increasing importance with growing performance dispersion between strong- and weak-performing issuers within the same credit tier.

For active investors, increased dispersion and short-term, news-related volatility can bring opportunity. An example of the latter occurred in airport bonds in 2020 amid the onset of the pandemic, broad-based flight cancellations and government-imposed social distancing measures. Hindsight has shown this was actually a historic buying opportunity for investors who realized airport operators were in a strong liquidity position, flexible on capital spending, and had lease agreements with airlines and vendors that brought strong revenue protection. This is obviously a different situation than the conditions affecting hospitals in today’s environment, but it plays into the same narrative: Long-term investors with deep credit research abilities can uncover attractive pricing for issues with solid long-term fundamentals.

Although the short-term fluctuations can be unsettling, these dislocations between performance and underlying fundamentals may allow active management to take advantage of such conditions. While our overweight to the hospitals compared to peers has been a headwind to performance over the last few quarters, we are excited about the sector’s prospects today and believe our opportunistic adjustments in the current environment will drive performance going forward.

Unless otherwise noted, all discussions are based on U.S. markets and U.S. monetary and fiscal policies.

Asset allocation or diversification does not guarantee a profit or protect against loss in declining markets.

No investing strategy can overcome all market volatility or guarantee future results.

The value of investments and any income from them is not guaranteed and may fall as well as rise, and an investor may not get back the amount originally invested. Investment decisions should always be made based on an investor’s specific financial needs, objectives, goals, time horizon, and risk tolerance.

Market forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

Equity Investing Risks

The value of investments in equity securities will fluctuate in response to general economic conditions and to changes in the prospects of companies and/or sectors in the economy. While growth stocks are subject to the daily ups and downs of the stock market, their long-term potential as well as their volatility can be substantial. Value investing involves the risk that the market may not recognize that securities are undervalued, and they may not appreciate as anticipated. Smaller companies tend to be more volatile and less liquid than larger companies. Small cap companies may also have more limited product lines, markets, or financial resources and typically experience a higher risk of failure than large cap companies.

Fixed-Income Investing Risks

The value of investments in fixed-income securities will change as interest rates fluctuate and in response to market movements. Generally, when interest rates rise, the prices of debt securities fall, and when interest rates fall, prices generally rise. High yield securities, sometimes called junk bonds, carry increased risks of price volatility, illiquidity, and the possibility of default in the timely payment of interest and principal. Bonds may also be subject to other types of risk, such as call, credit, liquidity, and general market risks. Longer-term debt securities are usually more sensitive to interest-rate changes; the longer the maturity of a security, the greater the effect a change in interest rates is likely to have on its price. 

The credit quality of fixed-income securities in a portfolio is assigned by a nationally recognized statistical rating organization (NRSRO), such as Standard & Poor’s, Moody’s, or Fitch, as an indication of an issuer’s creditworthiness. Ratings range from ‘AAA’ (highest) to ‘D’ (lowest). Bonds rated ‘BBB’ or above are considered investment grade. Credit ratings ‘BB’ and below are lower-rated securities (junk bonds). High-yielding, non-investment-grade bonds (junk bonds) involve higher risks than investment-grade bonds. Adverse conditions may affect the issuer’s ability to pay interest and principal on these securities.

This material 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.

The views and opinions expressed are as of the date of publication, and do not necessarily represent the views of the firm as a whole. Any such views are subject to change at any time based upon market or other conditions and Lord Abbett disclaims any responsibility to update such views. Lord Abbett cannot be responsible for any direct or incidental loss incurred by applying any of the information offered.

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.

Please consult your investment professional for additional information concerning your specific situation.

Glossary & Index Definitions

A general obligation (GO) bond is a municipal bond backed by the credit and taxing power of the issuing jurisdiction rather than the revenue from a given project.

revenue bond is a municipal bond supported by the revenue from a specific project, such as a toll bridge, highway or local stadium.

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