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Article Excerpt
Abstract
This study examined the effects of managed care organizations (MCOs) on the yields paid by U.S. hospitals on newly issued debt. The analysis improved on existing studies by utilizing a two-stage method that compensated for both simultaneity and self-selection effects. A reduced form probit analysis was first used to identify the factors determining whether hospitals in a random sample of 717 issued new debt in the study period (1995 and 1996). Bond yields were then analyzed using a second stage reduced form regression, incorporating selection effects, for the subset of 58 hospitals that had issued fixed rate debt. The results demonstrated that MCOs had only a modest positive influence on hospitals' costs of capital. Of greater import were insurance status, length of stay, and teaching status, with investors demanding greater yields for bonds issued without insurance and from hospitals with either longer lengths of stay or medical residency programs. (JEL I1)
Background
The long-term capital requirements of U.S. hospitals have been increasing to support new initiatives and to replace physical plants that continue to age [CHIPS, 2002]. These hospitals depend on tax-exempt debt financing as their primary (>70 percent) source of long-term capital [Grossman, 1993]. While governmental finance authorities usually issue bonds on behalf of hospitals, such authorities ordinarily do not back the bonds. Instead, nearly all (95 percent) of such issues are general revenue obligations of the hospitals.
In the past decade, declining interest rates and a growing need for investment in new technology and facility renovation have spurred hospitals to issue new debt [WSJ, 1994]. At the same time, the credit quality of hospital bonds has decreased due to cutbacks in governmental reimbursement, the threat of major health care reform, increased competition and the growing presence of managed care, which have combined to increase the financial risk associated with hospitals. Both major ratings agencies, namely Moody's and Standard and Poor's (S&P), have recently lowered bond ratings within their health care portfolio and expect downgrades to accelerate in the future [Ramundo, 1999; Arrick and Keller, 1999].
Prior research, reviewed below, has found that the dominant factor determining the cost of debt capital for hospitals is the underlying financial strength of the organization(s) responsible for making timely payments to investors. Other research has also shown that managed care insurers, by decreasing hospital utilization and reimbursements, have had an adverse effect on hospital profitability [Clement Grazier, 2001; Thorpe et al., 2001; Jordan, 2001; Young et al., 2002]. This study bridges the two research areas by assessing whether managed care organizations (MCOs), through their influence on expected profitability, have made it more difficult for hospitals to raise capital, thereby depressing their ability to maintain or improve their facilities. The specific research question addressed is do MCOs increase the yields hospitals have to pay?
Prior Research
This section reviews the prior research not only on the determinants of hospital bond yields, but also of bond ratings and closures, because all three reflect the risk of issuer default. Bond yields, however, also reflect investor assessments of market risk arising from changes in inflation and interest rates.
Past research has consistently shown that indicators of financial viability have been the principal factors determining both hospital bond yields and their ratings, as well as the probability of hospital closure. Since bond ratings are designed to signal the probability of default, it is not surprising that the research has also shown that the yields demanded by investors are inversely related to the ratings assigned to bonds. Only one study, by McCue [1997], has examined the relationship between MCO penetration and hospital capital costs. His examination of 1990-93 new issues found that hospitals located in areas of high HMO penetration paid only marginally (19 basis points) higher yields. The study also showed that financial markets demanded greater yields from hospitals with poor cash flow and low cash reserves.
Grossman et al. [1993], analyzing 1980-88 financing, found that yields were lower for bonds garnering higher S&P ratings and for those issued in states with high income tax rates or mandatory rate regulation. They also demonstrated that investors demanded higher yields from hospitals with lower asset to liability ratios and lacking residency programs, and from those more dependent on the Medicaid program or located in states with higher unemployment. Sloan, Morrissey, and Valvona's study [1987] of 1978-82 issues also found that bond yields were inversely rated to ratings, and that yields were lower for hospitals with lower debt to equity ratios and for non-profits because of tax preferences. Contrary to Grossman et al. [1993], their analysis showed that state rate regulation programs increased the cost of hospital debt, by depressing bond ratings. Carpenter's review [1991] of 1982-4 issues found that yields were inversely related to hospital size, occupancy and the ability to meet debt service payments. Yields were also lower for bonds backed by private bond insurance. Carpenter's reanalysis [1992] of the same data, correcting for simultaneity and sample selection effects, found that mandatory rate regulation increased the yields demanded by investors, and larger issues paid lower rates. The reanalysis concluded that hospital financials and occupancy determined which hospitals issued bonds, but not the yields paid. Cleverly and Rosegay [1992], analyzing tax-exempt bonds issued between 1975 and 1977, demonstrated that investors demanded higher yields on bonds assigned lower ratings by either Moody's or...
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