„Medicare for All“ rattles US healthcare

The US healthcare sector’s positive earnings releases are currently overshadowed by intense political debate over the future of the entire healthcare system. Hence, after a strong performance in 2018, US healthcare stocks have had a turbulent year to-date relative to the broader market. Volatility in the sector peaked in mid-April, as the debate became more heated. As a result, the S&P Healthcare sector dipped into negative territory on April 17  before recovering slightly to +2.6%, while the S&P 500 is powering ahead to new all-time highs, delivering +17.4% year-to-date (both returns as of 29/04/2019).

The most expensive healthcare system lets down almost 10% of the population

The US has the most expensive healthcare system among developed nations, with the overall share of GDP relating to healthcare spending at 17.9% in 2017. On a more representative per capita basis, the US spends almost double the amount compared to many European countries at USD 10,000 versus around USD 5,000 (see chart 2 below; total includes private and public spending, PPP adjusted). The Affordable Care Act, dubbed ‘Obamacare’, managed to lower the percentage of uninsured, but 10% of the population is still left without coverage, a significant social concern, especially when considering how high healthcare costs are in the US.

If we look at the cost within the US healthcare system, one of the main causes of higher expenditure is the outsized litigation risk that practitioners in the US face. Consequently, it would be wrong to blame pharmaceutical companies alone as the source of the problem. Even though there have been specific treatments that have seen large price increase, the pharma industry as a whole only retains two-thirds of every US dollar spent on pharmaceuticals. As can be seen in chart 4 below, the healthcare industry consists of many more branches besides pharmaceutical companies, which all take their share throughout a relatively inefficient value chain.

As the presidential election gets closer, the debate on how to reduce cost and change the current system is heating up. There are several visions on how to fix it, including Republican as well as Democratic versions, but seemingly there is still no consensus on the way forward. The main points being discussed are:

• Scope: Universal coverage for everyone vs. opt in (via employer or private plan)
• Coordination: Replace, complement or keep private/employer-based insurance
• Funding: Premiums vs. free (tax-based)
• Regulation: Centralize price negotiations and/or regulate prices directly

While Republicans focus on value-based healthcare and protection for people with pre-existing conditions, Democrats promote the idea of ‘Medicare for All’. Medicare is a national health insurance program that provides insurance for people aged 65 and older. Younger people with certain disabilities are also eligible for Medicare. The idea of ‘Medicare for All’ pushes to expand coverage to the broad public, the majority of which is currently covered by employer-sponsored health plans. Despite the catchy buzzwords used by Democrats, they are far from in agreement on the exact details of how ‘Medicare for All’ would look in practice. The various concepts being discussed are outlined in the below list.

The bill proposed by left-leaning presidential candidate Bernie Sanders, which is also supported by several other Democratic candidates, has been discussed most widely. He envisions a tax-funded universal so-called single-payer health insurance plan that provides insurance coverage for all Americans. It would strongly limit the role of private health insurance companies.

Consequences for the healthcare sector

Industries that are most directly affected by these discussions are health insurance companies and hospitals. Second round effects would potentially put pressure on medical device and biotech companies.

Health insurance companies

Health insurance companies manage healthcare services for private and public plans. As the 2017 Health Insurance Coverage Report of the U. S. Census Bureau shows, 67% of the American population had a private plan in 2017, including employment-based plans (56% of population). While the government bears the insurance risk for the public plans (most prominently for Medicare and Medicaid), health insurance companies offer administration and provider negotiations for those plans. Employers choose risk-based products where the risk is with the insurance company, or they elect to bear the risk themselves and hire the insurance company for ASO (administrative services only), where the insurer collects a fix monthly fee per member.

The role of private and employer-based health insurance under ‘Medicare for All’ is not clear yet. The financial market currently is focused on a scenario where private risk-based health insurance companies could be limited to manage healthcare, while the government would take on centralized risk-bearing. This would eat into the margins of insurers. An analysis of operating margins per reporting segment of health insurer Anthem shows the detrimental impact this could have on the broader sector: During the first quarter 2019, the operating margin earned within the Commercial & Specialty Business was 16.9%, while it was only 2.6% within the Government Business (link to full data set on Anthem website). A single-payer solution does not necessarily mean that private health insurance will fully disappear but it would certainly be limited to non-basic coverage products.

Hospitals

Hospitals are the other subsector that would be adversely affected by ‘Medicare for All’. Even under the current system there is a wide gap between payments of private insurers to hospitals versus government-sponsored plans for the same care, as the chart below demonstrates. Therefore, hospital revenues and margins would be pressured if the more profitable business with private payers would disappear.

Impact on medtech and pharma companies

Medtech companies would suffer from second order impacts as hospitals are by far their biggest customer group. Pharmaceutical companies in general are at risk to be adversely impacted from the broad political agreement that there needs to be more efforts to curb drug price increases. Both segments tend to have broad geographical diversification but tend to subsidize international markets at the expense of the US business.

Our view on the likelihood of ‘Medicare for All’

While we recognize that healthcare is a big social concern for the US, it is also a highly contentious topic that has the power to mobilize voters. In our view, Bernie Sanders is making a strategic step in moving forward with an actual proposal. The level of attention the topic gets, however, does not speak to its political feasibility. A left-leaning version of ‘Medicare for All’ would face significant opposition in Congress, and even if Democrats were to win a clean sweep (controlling the White House as well as both chambers of Congress), a healthcare reform would present itself as a very challenging undertaking for a number of reasons.

Firstly, as we have outlined, the Democratic Party currently lacks a united vision on the design and funding of a ‘Medicare for All’ programme. Secondly, some of the suggestions for funding measures include increasing corporate and income taxes, something we feel would remain highly controversial across both Democrats and Republicans.

Thirdly, we feel any sustainable reduction in costs would have to address the issue of litigation risk within the industry, which would ultimately involve Tort reform – an issue that divides political parties further. Despite these significant obstacles for ‘Medicare for All’, we expect to see great focus on the topic and consequently would not be surprised to see continued volatility in the run up to the presidential election.

How we position within convertible bonds

Ultimately, we feel the debate around ‘Medicare for all’ will lead to increased uncertainty and possibly stricter regulations within the healthcare sector, prompting us to prefer names with a convex profile and a stable bond floor. We have reduced our overweight in medical device companies and we don’t have any exposure to hospital or health insurance companies.

However, in biotech we see value due to a number of structural themes. Biotech companies with exposure to new and innovative therapies, specifically gene therapies, remain attractive to big pharma companies, which continue to fight against stagnant growth, expiring patents and aging blockbuster drugs. We expect that they will use their low leverage and large cash balances to acquire these smaller biotech companies, as evidenced by Roche buying Spark Therapeutics in February for a 100% premium. But also outside of gene therapy there is appetite for M&A in the pharmaceutical sector. At the beginning of 2019, Bristol-Myers Squibb bought Celgene for USD 82.8 billion. Eli Lilly acquired Loxo Oncology for USD 8 billion and Danaher announced the acquisition of GE’s Biopharma business for USD 21 billion.

How we position within corporate bonds

Ultimately, it must be remembered that US presidential elections are 18 months away and it is still unclear whether we will see any amendments to healthcare policy at all. However, given our expectation of higher volatility into elections we are focused on evaluating whether current credit spreads provide a suitable cushion from a fundamental and headline risk perspective.

Currently, we are defensively positioned within health insurance and avoid issuers with a high yield rating. We feel comfortable with our overweight in defensive pharma companies that have a below-average US revenue share and promising product pipelines, but nevertheless we avoid names that are at risk of levering up to fund acquisitions. Within the hospital sector we are overweight a single issuer where we see a strong de-leveraging profile on the back of an asset sale which should be realised well before elections, at which point we will look to go underweight.  Lastly, we still like medical device companies, where we see beneficial valuations or expect positive fundamental developments that offer the potential for rating upgrades.