Covenant Violations Could Continue To Affect Certain Health Care Credits

Increased frequency of financial covenant violations over the past few years

Beginning with the COVID-19 pandemic, S&P Global Ratings observed more potential and actual financial covenant violations in U.S. not-for-profit health care issuers for a variety of reasons that have evolved. Unlike early in the pandemic, when covenant violation risks were often tied to one-time events and mandatory stoppage of services, the trend has shifted to challenged operating situations for issuers, given the continued industry pressures.

With ongoing labor shortages and inflationary pressure on expenses, many organizations have experienced increased operating losses and diminished unrestricted reserves that, in some cases, compromised their financial covenants. In addition, investment market volatility in 2022 resulted in weak nonoperating income, exacerbating pressure on cash flow and debt service coverage.

In 2022 and 2023 we observed potential covenant violations for organizations across all rated categories, but recent trends indicate that the more challenged providers are at greater risk for violating their covenants, sometimes for a second year in a row. Rates of performance recovery differ, but covenant violations are likely to continue for those issuers that remain financially challenged, continue to have a meaningful mismatch of expenses and revenue, or whose balance sheets deteriorated.

Most frequent covenant violations in recent years have generally been tied to debt service coverage

The most common financial covenant violation within our rated universe in recent years has been debt service coverage. Some violation of days'-cash-on-hand or debt-to-capitalization covenants have also transpired, but those generally occurred in conjunction with a violation of debt service coverage.

The testing date of covenants and specific calculations for any covenant calculation may differ from S&P Global Ratings' calculations. For example, S&P Global Ratings calculates maximum annual debt service (MADS) coverage on a consolidated system, and the calculation, per bond or loan documents, may require the obligated group just on actual debt service. If bond documents outline that covenant testing occurs more frequently through the year (quarterly or semiannually), that could necessitate more ongoing management focus for the waiver and forbearance process, especially if an issuer is in a financially challenged situation.

Finally, we recognize that many issuers, particularly those that were stronger or rated much higher, were able to amend some of the financial covenant language in bond documents to make terms and definitions more favorable for the obligor at the start of the pandemic, especially given the extraordinary circumstances that could contribute to a covenant violation. Given that these credits generally have stronger overall financial profiles, this has minimized the need to obtain waivers as a result of a technical covenant violation, reduces the risk related to potential debt acceleration, and allows more time for management to focus on recovery efforts and improving key operating metrics. Although we recognize changes to bond documents related to covenants can affect investors, if there's underlying credit quality deterioration for any entity, we're capturing that in our annual credit review update, or if needed, more frequently through our event-driven review process.

Key points of management conversation regarding a potential or actual covenant violation

As part of our surveillance efforts, we are checking in with management more frequently throughout the year when we see a risk of a covenant violation, especially in cases of heightened risk of debt acceleration or cross-default. If a violation is likely or has already occurred, we ask management teams a host of key questions (in addition to reviewing the bond documents) during our annual or event-driven review, including:

• Is the covenant violation signaling any risk of nonpayment, or is it considered a technical covenant violation?
• If it is a technical covenant violation, is it an event of default per the bond or loan agreements, and what are the remedies? Is there any risk of acceleration of debt payments or cross-default provisions?
• If the technical covenant is not an event of default, what are the potential outcomes (consultant call-in, collateral posting, other)? If collateral posting is required, are enough unrestricted resources available and what impact might that have on liquidity?
• Does management expect the covenant violation to be one-time, or will it have to be managed quarterly, semiannually, or for a longer period? When does management believe the credit will be in compliance again with measured covenants?
• Does the covenant violation signal underlying credit weakness that we believe should be incorporated into our credit view, or is the violation more a function of a one-time issue or situation?
• Is management in communication with lenders or bondholders regarding obtainment of a waiver or forbearance agreement, and how are those discussions progressing? If the organization is under a forbearance agreement, what are some of the specific discussion items that have been agreed to?
• What are your specific initiatives and plans to meet covenants in the subsequent measuring period or fiscal year?

Not all covenant violations lead to a negative rating action, but most of the recent covenant violations occurred in conjunction with credit deterioration

Covenant violations do not always lead to a rating or outlook action, but will likely depend on our view of the underlying cause, expected duration, and possible liquidity pressure as a result of either a forced debt repayment, debt acceleration, or collateral posting requirements. Many organizations that had a negative rating outlook prior to the covenant violation typically maintained the rating and outlook even after a full review, demonstrating our view that a covenant violation in itself doesn't necessarily result in a rating action. To date, negative rating actions or outlook revisions to negative following a covenant violation have generally been tied to our view of deterioration of underlying credit quality and/or heightened risk to liquidity (as a result of either credit deterioration or the covenant violation or both).

Favorable outlook revisions (generally to stable from negative) were given once organizations had minimized acceleration risk by paying off bank debt (with generally stricter covenants and/or events of default) or sustained a solid financial rebound with improved liquidity and financial flexibility for the rating to minimize future covenant issues. In addition, a waiver or forbearance agreement might stem further rating pressure, depending on specific negotiated agreements.

In some cases, organizations with deteriorating credit fundamentals and covenant violations were able to merge with a stronger issuer. These issuers, whose own credit quality saw no or minimal underlying improvement, experienced a positive rating action given their merger with financially stronger organizations.

Covenant violations occurred most in health care credits in the 'BBB' category and below, but all rating categories were affected to some extent over the past several years

We observed about 30 of our rated credits experiencing some kind of covenant violation beginning with their 2022 financial results. Of the observed covenant violations, about 60% were in the 'BBB' or speculative-grade category. Speculative-grade issuers accounted for one-third of the total violations but represent just 10% of the total rated universe. However, higher-rated issuers were not immune, as slightly fewer than 35% of the observed covenant violations occurred in the 'A' rating category, and at least one in the 'AA' category.

Case Studies

We highlight below a few case studies of some of the more challenging credit situations in which financial covenants were violated or had a very high likelihood of violation. For these situations, a covenant violation can be a clear warning sign, although these issuers were already experiencing operating pressure or financial distress.

Beverly Community Hospital Association, California

Most recent rating action (May 2023): Lowered to 'D' (subsequently withdrawn).  Following several years of financial performance volatility stemming from the pandemic and industry difficulties, we lowered the rating to 'CCC-' from 'BB' on Nov. 16, 2022, as nine-month interim financial results indicated that the hospital was at considerable risk of an event of default and possible acceleration of its debt given the high likelihood that it would violate one or both of its days'-cash-on-hand or debt-service-coverage covenants.

At that time, we believed that management would seek waivers from bondholders if necessary but was also in the early stages of a potential merger with a large health system in California. During subsequent reviews the hospital tried to affiliate with two health care systems, but neither attempt moved forward. We then lowered the rating to 'CC' following the April 19, 2023, announcement from Beverly that it had filed for Chapter 11 bankruptcy. We then finally lowered the rating to 'D' following the trustee's April 26, 2023, disclosure of a notice of an event of default. While covenant violations were not what triggered the event of default, the potential violation of days' cash on hand and debt service coverage was the initial warning sign from a credit perspective.

Catholic Health System, New York

Most recent rating action (May 2023): Affirmed at B-/Negative.  Catholic Health System, N.Y., entered into a forbearance agreement with its trustee, UMB Bank, on May 8, 2023, because the system violated the debt service coverage covenant under the master trust indenture for the second year in a row. This led to an event of default that would have triggered acceleration and immediate repayment of the bonds if the forbearance agreement had not been obtained.

The system had a multiyear trend of significant operating losses and diminished unrestricted reserves as a result of elevated labor costs and inflationary pressures, and experienced a labor strike that led to acceleration in losses in fiscal 2022--all of which we incorporated into our credit view and the 'B-' long-term rating.

The forbearance agreement runs through June 2024, includes an annual 1x debt service coverage requirement, and additional debt is limited to $10 million over the term of the agreement. The agreement also includes enhanced monthly reporting requirements. However, we note significant operating improvement at the system in the interim period ended Feb. 29, 2024, and will monitor the situation as the forbearance agreement ends.

Marshfield Clinic, Wisconsin

Most recent rating action (March 2024): Lowered to BBB/Negative.   Marshfield Clinic is navigating financial covenant violations on its bank debt that began with its 2022 financial results and that are likely to affect the organization for at least the first half of 2024, though it has all the appropriate covenant waivers through fiscal 2023 from the banks.

As a result of covenant violations, negotiations on waivers required Marshfield to post collateral by a specific date for covenant violations and if a merger being contemplated (with Essentia Health) was not completed by a specified date. Lines of credit (fully drawn) with three different banks expiring March through May 2024 further complicate the system's financial situation. A covenant violation for master trust indenture debt is not an event of default until at least 2026. Management has been in discussion with its bank partners and we expect Marshfield to achieve some resolution related to the covenant issues and near-term liquidity pressures by refinancing its bank debt through a combination of public and/or privately placed debt and paying a portion down of the amount drawn on its lines of credit.

The recent negative rating action reflected our view of Marshfield's continued challenged performance and a balance sheet with less flexibility as a result of declines in net assets as well as moderately higher debt resulting from debt issuances needed to maintain liquidity. We monitor the situation, as ongoing operating pressures could continue to affect the system's ability to meet financial covenants if bank debt is not refinanced, and any meaningful declines in cash and reserves could pressure the rating further. That said, we understand that Marshfield is actively working through its bank-related issues.

Amy He and Melody Vinje contributed research to this report.