Our Rating Perspective

Rating activity and the rating outlook profile support our revised view of the health care services sector as stable overall. The sector issuers that we rate performed relatively well in 2024, a trend we expect to continue in 2025. Our ratings profile, including the distribution, bias, and composition of the group with negative outlooks, suggests a more stable view with relatively balanced rating activity.

The ratings distribution in the sector favorably reversed after several years of credit deterioration (Chart 1). Currently, we rate 61% of the companies in this portfolio 'B-' or below. This follows a multiyear skid when these entities were 41% of ratings in 2021, 53% in 2022, 64% in 2023, and 61% in 2024. However, we view this as a sign of more stability rather than improving rating quality because the numbers are somewhat skewed.

Chart 1

The portfolio now excludes several companies that had very low ratings and are no longer rated because they filed for bankruptcy, defaulted, or went to the private credit market.

Credit quality weakened the past few years with downgrades far exceeding upgrades (excluding companies that we upgraded following a selective default). Moreover, the concentration of downgrades was with lower-rated companies, including those in distressed situations that involved debt restructurings (Charts 2 and 3).

Chart 2

Chart 3

Our ratings bias has improved.   In April 2024, of the ratings on 67 companies in health care services, 18 had negative outlooks and none had positive outlooks. Today, of the ratings on 61 companies, 11 have negative outlooks, four have positive outlooks, and one has a developing outlook. About half of these companies are already in the 'CCC' category, and 45% are physician services companies.

The percentage of health care services companies with negative outlooks declined to about 18% from 26% (Chart 4). While this is still high, about half are concentrated in physician services. Our forecast of this subsector is still relatively weak due to difficulties with the supply of physicians and an adverse reimbursement environment.

We view the preponderance of the other subsectors in health care services to be more balanced. Additionally, except for many physician services companies, we believe several with negative outlooks have shown signs of improvement, increasing the likelihood that we will revise the outlooks to stable as opposed to lowering the ratings.

As of Dec. 31, 2024, we rated 13 health care services companies in the 'CCC' category or below, compared with 14 as of April 2024, four in 2022, and only one at the end of 2021. The portfolio still has a higher percentage of negative outlooks than the pharmaceutical portfolio, but less than the medical equipment portfolio.

Chart 4

Industry conditions are relatively good, but companies must remain proactive.   For most health care services subsectors, industry conditions have improved. The most common pain points, including labor and inflation, have eased significantly. Major industry disruptions such as the COVID-19 pandemic, subsequent labor challenges, and very high inflation are falling further in the rear-view mirror. Most notable has been less use of contract labor, a substantial contributor to better operating results. Demand for services remains solid across most subsectors, a trend we expect will extend through at least most of 2025. Reimbursement will remain a chronic issue with these companies. Although the environment is relatively stable for now, companies cannot become complacent.

Many health care services companies have actively taken the opportunity to reassess, adjust operating strategies to meet shifting challenges, and implement new or revised strategic initiatives to improve performance based on updated growth expectations. They're also taking on the reality of a higher expense base resulting from high inflation, permanently higher labor costs, and higher borrowing costs. These developments, which were not anticipated just a few years ago, have caused many companies to pursue even more aggressive cost-efficiency measures. Commonly these measures include staffing model revisions and portfolio rationalization decisions. Often, these carry meaningful implementation costs that could burden near-term operating results and cash flow, but improve the chances of success later.

Very low-rated, highly leveraged companies will continue to struggle.   Although in 2025 we expect the continued improved conditions of 2024, the most vulnerable firms remain those we rate in the 'CCC' category. Several are aggressively revamping their businesses, improving operating performance, and showing signs of generating free cash flow. Others are still struggling because they may not have enough cushion or time to realign their operating strategies. Factors include burden from higher interest rates, declining liquidity due to ongoing cash flow deficits, and upcoming debt maturities. Fewer companies in our portfolio are struggling than in the past few years. Still, with 21% rated in the 'CCC' category, we expect some distressed situations, but fewer than the past couple of years.

Health care services companies are strategically more focused on the changing landscape.   Since the pandemic, in addition to operating challenges that have added to margin headwinds, many are revising their long-term strategies. Demand remains good, although unequal across all subsectors. Inpatient admissions in the U.S. have been declining for years despite the aging population while outpatient services are expanding. Reimbursement challenges, technology advancements, and changes in patient preferences (including the adoption of virtual health care) are changing how people access care. Margin headwinds have increased, requiring companies to more closely evaluate the markets they want to operate in, their service mix, reimbursement environment, and competitive landscape.

Among the strategies becoming more popular include hospital systems diversifying further into non-acute-care services, including outpatient services; health care services companies broadly exploring joint ventures to enter partnerships and minimize capital needs; and increasing capital allocation to higher-acuity, higher-margin services.

We don't expect many large, transformational mergers and acquisitions. Given the very low rating distribution of our portfolio, many of these companies simply don't have the capacity for significant transactions. Instead, we expect them to continue to improve business portfolios by exiting noncore markets and services and investing in existing markets to increase scale, improve competitiveness, and seek market share gains.

Key Things To Watch

Patient volume expectations.   Patient volume was good in 2024, but we believe it may start leveling off this year. Patient volume benefitted from several factors, including some catch-up on deferred care as the labor situation continued to improve, which benefitted capacity. We also saw a boost to inpatient admissions that coincided with Medicare's application of the two-midnight rule for Medicare Advantage plans, which also hurt outpatient volume. The two-midnight rule means that if the patient requires care over two midnights, the insurer must cover that hospital stay as an inpatient. We expect the long-standing trend of more health care being delivered in outpatient settings to continue this year. The trend for specific health care services subsectors will continue to vary based on the strength of the markets they operate in, local market position, ability to manage reimbursement, payer mix challenges, and cash flow management.

Cash flow/capital structure.  Like last year, our concerns for health care services companies remain elevated because these are the most significant factors behind downgrades and negative outlooks for this very low rated portfolio. Cash flow for health care services companies as a group has generally been better, but it remains weak for many highly leveraged companies that we rate 'B-' and below. We expect fewer distressed situations than last year because several companies restructured and others are improving.

However, even for some low-rated companies reporting better operating performance and cash flow, the pace of improvement may be slow. We don't expect interest rates to decline much, thus cash interest expense will likely remain high. Furthermore, some companies still contend with working capital difficulties from the No Surprises Act or may still need to repay loans taken from Change Healthcare Holdings Inc. after its cyber attack. In addition, several still have to manage upcoming debt maturities.

Health care policy.   We believe the new administration's potential health policy positions will be a net credit negative for health care services companies (See "The Health Care Credit Beat: Republican Red Wave A Net Negative For Health Care", Dec. 2, 2024.) While there is significant uncertainty, we believe potential policy changes could increase downside risk across the portfolio, though we expect limited credit impact over the next year or so.

The most important factors we are watching are the Affordable Care Act (ACA), Medicare, and Medicaid:

• We do not believe the ACA will be repealed, but we are not certain whether premium subsidies set to expire in 2025 will be renewed. If not, the uninsured population will increase, potentially raising bad debt or hurting patient volume for some companies.
• Medicare continues to increasingly transition to Medicare Advantage, which is operated by commercial insurers. It appears the new administration intends to aggressively push the MA model and make it the default option. This could be viewed as a privatization of Medicare that would likely further reduce the already lower margins for most health care providers compared with traditional Medicare.
• Medicaid funding could be more at risk as the Trump administration looks to reduce spending on this program. Cuts in the federal portion would most certainly impair health care services companies.

Related Research

• The Health Care Credit Beat: Republican Red Wave A Net Negative For Health Care, Dec. 2, 2024