Downgrades exceeded upgrades in 2022 due to large losses from the pronounced labor shortage, discontinuation of CARES Act funding, and unpredictable volume. Normally reliable reserves that would cushion operating pressure and thwart a rating downgrade in the past were absent in 2022 given market turbulence. While the industry has experienced difficult operating periods and volatile stock markets in the past, the simultaneous impact of these two forces in 2022 was a first in not-for-profit healthcare, creating a financial “twindemic” that drove many of the downgrades.
In any year there will be a “story credit” whose rating is downgraded multiple notches (two or more ratings) in one rating action. The multi-notch downgrade is typically driven by a failed strategy or unexpected event that materially weakens credit quality. Unlike prior years, however, 2022 saw a rise in the number of multi-notch downgrades, particularly at the lower end of the rating scale, as losses were significantly above expectations and likelihood of bond covenant violations escalated. Multi-notch downgrades are an ominous sign for the industry, and it’s fair to predict that there will be more multi-notch movements in the months ahead as FY 2022 audits are released.
As an advisor, I would tell you that hospital management teams should do everything to avoid a rating downgrade. As a seasoned credit analyst, I would tell you that the key to avoiding a downgrade is the demonstrated durability of stable financial performance or a methodical pathway to get there, quickly. Speaking from both roles, I would tell you that avoiding riskier strategies to maintain a rating is not a viable long-term strategy. If debt is needed to fund strategies to ensure long-term viability of an organization, then a manageable increase in debt should be considered, even if it results in a rating downgrade.
Every assigned rating has a bandwidth for variable financial performance or additional debt. A rating that is viewed as strong within its rating category will likely have incremental debt capacity before a downgrade ensues. Hospitals that are “thin” in their rating category may have limited debt capacity. These ratings may be sitting on the “tip of the spear” such that any variance from budget or increase in debt will cause a downgrade.
The not-for-profit industry averaged a 2.0% operating margin in the years leading up to the pandemic, hardly enough to fund routine and strategic capital, contribute to pensions, pay debt service, and build reserves. Performance is weaker today as Kaufman Hall’s year-to-date median through November 2022 shows hospitals just below breakeven performance (-0.2%). Many organizations suspended capital during the early days of the pandemic, but hospitals can only hold their capital breath for so long due to the need for state-of-the-art facilities. Unlike for-profit hospitals that can raise both debt and equity, not-for-profit hospitals only have debt as their main source of capital.
Rating downgrades are tough to deliver and tough to take as ratings have become a source of organization pride, well beyond their original singular purpose to communicate default risk. Over the life of a long-term bond, there is a good chance that a hospital rating will experience pressure volatility given the enterprise risk inherent in the industry; those that don’t are rating unicorns. The good news regarding ratings in 2022 is that the overwhelming majority of not-for-profit hospital ratings were affirmed, denoting the willingness of the rating agencies to give the benefit of the doubt, even during a financial twindemic, when there is a cogent plan to stabilize performance.