With the coronavirus pandemic slashing hospitals' revenue and cash flow, the number of organizations that breach their debt covenants is likely to tick up in 2020.
Federal stimulus grants under the CARES Act may mitigate some of those risks, but nevertheless, a new report from Moody's Investors Service predicted that hospitals will have a difficult time staying in compliance.
Much is still up in the air with respect to hospitals' financial futures, given the uncertain pace of recovery as elective procedures resume, which will vary by region. It's also unclear whether the suspension of elective procedures due to the global pandemic will afford hospitals protection from breaches under their bond agreements.
Hospitals are expected to lose an estimated $202.6 billion from March 1 to June 30 due to canceled procedures and the higher cost of labor and supplies during the pandemic, according to the American Hospital Association.
At Care New England, Providence, R.I., for example, non-emergent surgeries are at 60% of their pre-COVID-19 levels after the three-hospital health system resumed such procedures on May 11. Still, the ramp-up will be slow and the crisis has done a number on the system, which raises the risk of covenant breaches, said Joe Iannoni, Care New England's chief financial officer.
"It is a concern," he said. "We're working on it. The solution is more funds from the state and the federal government, but that can't solve all of our problems. So we are working on a solution for that."
Moody's said it's also too early to know whether a second wave of COVID-19 cases will strike later this year and, if so, whether it will hit regions already affected by the pandemic or emerge in regions largely unaffected thus far. The uncertain time frame of recovery adds to the challenge of assessing compliance with covenants, according to the report.
A covenant violation, otherwise known as a technical default, happens when a borrower falls short of the required financial terms of its bond agreement, including debt service coverage and days cash on hand. It's different from a payment default, which the report's authors said is not likely to happen.
The Moody's report said hospitals will more likely breach covenants based on their debt service coverage rather than their liquidity. That's because many hospitals received accelerated Medicare payments early in the pandemic, said Lisa Goldstein, an associate managing director with Moody's and co-author of the report.
"Liquidity for many is strong, higher than it was going into this because of the Medicare accelerated payments," she said. "Now, that said, these monies will have to be paid back. It's somewhat of a Band-Aid on liquidity as volumes started to plummet because of the restrictions on elective procedures."
The risk of breach will also be higher if hospitals have to measure covenants on a quarterly or semi-annual basis rather than annually. Hospitals with June 30, 2020 measurement dates face a near-term risk.
Care New England's fiscal year ends Sept. 30. Executives plan to work with investors over the summer if they expect to breach their covenants or come close to doing so, Iannoni said. He is concerned about meeting the debt service coverage covenant in particular. Days cash shouldn't be a problem, as the federal stimulus money provided a liquidity bump, he said.
"They're all willing to talk because it's a widespread issue across the country," Iannoni said.
Legal documents governing bonds often contain force majeure provisions that afford leeway in an unexpected environment like a global pandemic, the report said. The use of those provisions, however, is untested and would need careful consideration by legal teams. The interpretation of such contracts would be subject to state law.
"This may very well be the test case," Goldstein said.
In that vein, the Greater New York Hospital Association is calling on Congress to require that lenders provide relief from debt covenants on hospital loans to prevent the triggering of financial penalties.
Covenant violations pose risks to bondholders if investors or lenders choose to accelerate debt in the face of the default.
Moody's said the impact of covenant violations on hospitals' credit quality depends on whether the breach takes place in conjunction with fundamental operating issues, what steps management takes to avoid a breach and what likelihood there is the violation triggers default and accelerated debt payment.
Fitch Ratings placed 15 hospitals on rating watch negative in early April due to COVID-19 concerns. Care New England was one of them. Following the health system's recent review with Fitch, Iannoni said he expects a downgrade from its current BB rating.
"I would not be surprised with a downgrade based on the facts, the strength of the balance sheet, the crisis, the outlook for the industry and the state," he said.