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FOLLOW THE MONEY. That was the advice given by "Deep Throat" to Woodward and Bernstein in tracking down the Watergate scandal. And it's the credo being followed by the smart money in the health-care business.
While critics of health-care reform decry it as socialism, capitalists are moving quickly to stick their cups into the torrent of government cash that is about to be let loose in the sector.
And, as noted here a couple of days ago, one way for investors to take advantage of the health-care reform legislation is in the municipal bond market (See "Surprising Health-Care Winner: Munis," March 24,)
Sharply higher taxes to pay for the expansion of coverage for the uninsured make tax-free bonds an even more compelling investment for upper-income folks, defined as individuals making more than $200,000 or couples earning more than $250,000.
Beyond that, the health-care reforms just enacted have the potential to change the landscape for a range of participants in the industry, notably in the not-for-profit arena. These entities have in large part been financed in the tax-exempt bond market.
As John Loffredo of MacKay Shields, subadviser to the MainStay Tax Free Bond Fund (ticker: MTBAX), explains, not-for-profit hospitals should benefit from the extension of coverage to the previously uninsured. These hospitals currently have to absorb the cost of treating the indigent uninsured.
Now that some 30 million uninsured people will be covered by Medicaid or some form of subsidized insurance, not-for-profit hospitals, which disproportionately provided care for the uninsured, should benefit. States already suffering severe budget pressures from Medicaid will have to shoulder an even greater burden, however. But the bonds of hospitals that no longer will have to absorb the cost of indigent care should benefit.
That hasn't gone unnoticed in the private sector. "Any time the government starts spending money, the smart money follows," Loffredo observes. As a result, some not-for-profit hospitals are to be sold to private-sector operators that now can be more assured of reimbursement.
Cash-strapped Detroit is selling a hospital to a private operator while Boston Catholic health system is selling a hospital to a private-equity firm, Loffredo says. This provides a windfall in several ways.
Moving facilities from the not-for-profit to the private sector puts those hospitals onto the tax rolls, a boon for those localities. For bondholders, such a transaction results in the securities being "defeased," which means the bonds are backed by a portfolio of Treasury securities. The private acquirer isn't permitted to benefit from tax-exempt financing. But if the hospital's bonds can't be redeemed early, the acquirer buys Treasuries to pay off the muni bonds. So the munis are effectively backed by Treasuries.
As a result, the hospital bonds, which were rated at the lower end of the investment-grade scale, say triple-B, or even lower in the junk range, would suddenly be lifted to gilt-edged triple-A. The biggest winners in this process are hospital bond issuers in lower-investment-grade or speculative range, Loffredo explains.
Those are one-time windfalls. More importantly, not-for-profit hospitals will benefit from a sharp reduction in their indigent-care expenses. And these institutions comprise a large portion of the lower-grade muni market.
To tap opportunities in that sector, Loffredo says Mainstay will be launching a new, high-yield muni fund on March 31. Mutual funds make sense for investing in junk munis given the need for credit research and diversification. This is definitely a case of "don't try this at home."
Morningstar, the mutual-fund rating firm, picks the Franklin High Yield Tax Free Income Fund (FRHIX), which carries a maximum load of 4.25%, and the no-load T. Rowe Price Tax-Free High Yield Fund (PRFHX.) In addition, Morningstar calls the Vanguard High-Yield Tax-Exempt Fund (VWAHX) one of its picks among intermediate-term tax-exempt funds, not junk muni funds, given its strong investment-grade tilt notwithstanding its monicker.
One other aspect that Loffredo suggests to consider: the hikes in income-tax brackets resulting from the end of the Bush tax cuts and the Medicare taxes to be levied on upper-income investors' interest, dividend and capital gains income, means that fewer people will be snagged by the dreaded alternative minimum tax. The AMT rules say you pay the higher of your regular tax liability or the AMT. Now that the regular tax rate for ordinary income is certain to be higher, the AMT doesn't loom as large.
Be that as it may, not-for-profit health-care-related issues, historically among the riskiest in the muni market, should benefit from the just-signed reform legislation. Professionally managed funds with exposure to the sector are probably the best way for individual investors to benefit from the trend.
Comments: randall.forsyth@barrons.com
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