The Long and Short
A steeper curve presents buying opportunity in long-dated HCSERV bonds
Meredith Contente | January 8, 2021
This document is intended for institutional investors and is not subject to all of the independence and disclosure standards applicable to debt research reports prepared for retail investors.
Investors looking for additional yield in the relatively stable HMO sector should consider the Health Care Service Corporation (HCSERV (A3/A+/A-) which has one of the steeper 10s/30s curves among its lower rated peers. While the credit has tightened considerably over the past 6 months along with HMO peers, its curve has steepened by 15 bp as the 10-year bond has rallied slightly through ANTM. Investors can take advantage of the steeper curve and move into a credit that is both lower levered and has a much stronger risk-based capital ratio than ANTM.
Relative to Anthem Inc. (ANTM – Baa2/A/BBB), HCSERV’s 10s/30s curve stands at 40 bp (g-spread) while ANTM’s curve is currently at 35 bp (g-spread). Additionally, when HCSERV priced the bonds in May 2020, the curve at pricing was only 25 bp (155 bp on the 10-year versus 180 bp on the 30-year). HCSERV has long managed its risk-based capital (RBC) ratio above 700%, and it currently resides at just over 1200%, which is one of the highest among all of the HMOs and compares very favorably to ANTM’s which is roughly 250%. HCSERV’s risk-based capital redundancy is considered “AAA” relative to “AA” at ANTM, and the company is currently levered below 1.5x versus 2.4x at ANTM.
Exhibit 1. Single A – BBB HMO Spread Comparison (10-year to 30-year)
Source: Bloomberg TRACE; Amherst Pierpont Securities
Strength in members
Founded in 1936, HCSERV is actually the nation’s fifth largest health insurer and the largest customer owned health insurer in the U.S. by membership with over 16 million members. It is an independent licensee of the Blue Cross Blue Shield Association with core markets of Illinois, Texas, Oklahoma, New Mexico and Montana. Illinois and Texas remain its two largest markets with membership of 8.5 million and 5.7 million, respectively. Combined, Illinois and Texas account for roughly 89% of total members. While competition is strong in all five states that HCSERV operates in, the Blue Cross Blue Shield brand provides a sizeable competitive advantage for HCSERV for both network relationships and customer recognition.
As of 8/31/20, HCSERV’s membership increased nearly 2% from year-end 2019. Nearly 90% of the company’s membership base comes from commercial segments, i.e. group self-funded, group fully insured and individuals under 65 years of age, with only 10% from government sponsored segments of Medicare and Medicaid. By comparison nearly 30% of ANTM membership is from government sponsored programs. While government membership is fueling overall membership growth at ANTM, there tends to be more revenue and earnings volatility associated with the government segment. This is due to the size of the contracts, as wins/losses can create huge earnings swings. Additionally, there is more reimbursement pressure associated with government contracts. By maintaining strong commercial membership levels, HCSERV is able spread both risk and medical expenditures across a large enough membership base which helps to keep rising costs at a minimum. Currently, HCSERV’s administrative costs account for roughly 10% of each health care premium dollar.
Capitalization at the “AAA” level
HCSERV has long maintained strong capitalization and has financial strength ratings of AA- from S&P, A1 from Moody’s and A from A.M. Best. S&P noted when HCSERV came to market that the company’s capital levels are “comfortably redundant” at the AAA level. HCSERV has approximately $39 billion in statutory revenue and nearly $19 billion of statutory capital. HCSERV’s $2 billion three part bond deal issued at the end of May is the company’s only senior debt outstanding. The deal was essentially leverage neutral as proceeds were used to repay the $1.75 billion of borrowings from the Federal Home Loan Bank. Even after the deal its leverage remains low and favorable to peers at just below 1.5x debt to pre-tax income. This compares favorably to UNH’s leverage of 1.7x, HUM’s of 2.1x and ANTM’s of 2.4x. Additionally, HCSERV’s current debt to statutory capital ratio is just under 10%, which is considered very low. Once again this compares very favorably to its peers’ debt to total capitalization ratios with UNH at 41.8%, HUM at 33.7% and ANTM at 39.2%.
HCSERV has maintained an RBC ratio above 700% since 2015, and prior to that it was maintained above 500%. This is important as publicly traded peers typically maintain RBC ratios in the 200%-275%, while privately owned BCBS peers have RBC ratios in the 250%-500% range. With expectations for HCSERV to end 2020 with an RBC ratio at over 1400%, the company is likely to have the strongest ratio in the HMO space.
Exhibit 2. HCSERV’s RBC trend (2015-2021E)
Outlooks are stable
HCSERV’s ratings all currently have stable outlooks. S&P’s stable outlook reflects its view that HCSERV will be able to navigate the impact of COVID without any deterioration of credit quality. S&P also noted that the issuance in May does not affect the company’s AA- financial strength rating. While S&P notches the ratings of the notes one notch from the financial strength rating, the notching purely reflects the subordination of the debt relative to policyholder claims in the event of insolvency, and does not represent any weakness in the credit. Fitch’s stable outlook reflects its view that the balance sheet will continue to remain strong and any challenges to profitability presented by COVID, will not materially impact its strong capitalization. Additionally, the approval of vaccines is a positive step in creating effective immunization and helping to return the US and the world to a more normal social and economic environment. The sooner we reach herd immunity, the better for HMOs in reducing increased medical costs associated with the pandemic.