Capital market expectations have changed. Should health systems consider reducing risk and leaning into fixed income now?
- Three factors should be considered before reducing risk: the combination of historical returns and forward-looking expectations, the evolving cost of debt, and the impact on days cash on hand.
- All health systems should step back and consider the role of the long-term pool for the enterprise.
- Before making asset allocation changes, determine what risk can be tolerated and what return should be targeted for the next 5 to 10 years.
Many health systems base their long-term return objective on the long-term cost of capital, plus a margin. This aligns the portfolio with organizational objectives, because if the investment returns are not expected to exceed the cost of borrowing, it would call into question why capital projects are funded through borrowing rather than the assets being held.
A common way of analyzing the strategic asset allocation is to assess the likelihood of achieving the return objective over the next five, 10 and 20 years. Market return expectations at the time of the analysis are a critical variable in the determination of whether the organization is taking enough market risk to achieve its objective. This is sensible, as it’s important for an organization to know whether it can achieve its desired objective in the current market environment.
Currently, market return expectations are higher than they have been in previous years, causing some health systems to consider if they can achieve their long-term return objective while pursuing a less risky asset allocation strategy. We believe that the answer is not as simple as simply looking at what asset allocation is expected to achieve the stated return objective over the next 10 years and adopting that asset allocation.
We believe it is also important for health systems to consider three other factors:
- Interaction of historical returns and forward-looking expectations. Has the health system performed in line with its objective over the past three to five years? If not, should that deviation be incorporated into the forward-looking expectations?
- Evolving cost of debt. Is there the expectation that any future debt issued will have a significantly different cost than debt already issued? If so, should the forward-looking return objective be based on the cost of debt already issued? Or account for the potential need to issue debt at higher current market rates and therefore increasing the return objective?
- Impact on days cash on hand. Even if not explicitly part of the objective, if expense inflation is high, should that factor into the return needs of the portfolio?
Interaction of historical returns and forward-looking expectations
On December 31, 2017, if a health system wanted to target a return of 1.5% above its cost of capital, it would have first looked at recent debt issuance to calculate its cost of capital. The AA US Corporate Index Effective Yield was 2.8% on 12/31/2017. Assuming that reflected the cost of borrowing for a AA-rated health system, it would have led to a long-term total return objective of 4.3%. Although the return objective was moderate, yields were also low on investable fixed income, and equity market valuations were high, leading to low return expectations on global equity. At that time, a passive portfolio of 60% global equity and 40% core fixed income would have had a 10-year return expectation of 4.3%, in line with that potential return objective.
Fast forward five years later. Yields available on fixed income assets have risen and global equity returns expectations are higher. The 10-year expected return on that same passive 60/40 portfolio is now 6.7%. This is leading some health systems to wonder if it is possible to achieve their stated return objective with less equity risk, especially since greater operational uncertainty for some systems may lead to a preference to control risk on the investment side, rather than seek higher returns. Rising yields and corresponding increases on expected fixed income returns also mean there is less of an expected impact on total portfolio returns from reducing risk than there would have been a year ago. Reducing risk may be appropriate for a given organization, depending on its enterprise-level financial situation, but we don’t think that reducing risk is necessarily appropriate if the reason for doing so is because capital market expectations imply the same return can be targeted with less equity risk. For an organization to achieve its long-term objective, it needs to outperform its objective in favorable market conditions, knowing that it will lag its objective in negative market environments. In other words, sometimes not taking enough risk today creates greater risk in the future, when markets turn downward.
Some health systems are comfortable with their current risk level and are therefore happy to expect to outperform the stated return objective on a going-forward basis and therefore this doesn’t apply. For those that can’t tolerate their current risk level due to operational concerns even if the targeted return is sacrificed this also doesn’t apply. Others can tolerate their current risk level but are wondering if they can achieve their stated objectives with less equity risk due to an increase in capital market return expectations.
However as of December 31, 2022, the realized three and five-year returns on a passive 60/40 portfolio would have only been 1.9% and 3.8%. The shorter-term historical underperformance is not surprising, given that the improvement in return expectations has been caused by an improvement in market valuations, as a result of declining equity and fixed income markets through 2022. The exact performance relative to objectives will vary by health system, but we suspect that many health systems have underperformed long-term return objectives over the last three to five years. For this sample health system, incorporating that underperformance into its forward-looking objective could raise its target 10-year return by 0.3 to 0.7%. This lessens the ability to reduce risk within the portfolio, but implies that for many health systems, some equity reduction could be possible while staying on track to achieve the stated long-term return objective. The details will vary by system. And for some, it could eliminate the ability to reduce risk while staying on track for the long-term return objective.
Evolving cost of debt
For health systems that plan to issue new debt, the next consideration is this: Should the investment strategy focus on outperforming the current cost of capital, or outperforming the expected cost of issuing new debt?
If a health system is going to issue new debt to fund capital projects, rather than use assets in their long-term pool, the investment return will likely be targeted to outperform the cost of that new debt. Unfortunately, the rising interest rates that have led to increasing expected returns on investment assets have also increased the cost of future borrowing for health systems. That same benchmark AA yield that was 2.8% on December 31, 2017 increased to 4.9% on December 31, 2022. If an AA-rated health system looking to outperform that cost of debt by a margin of 1.5%, then that implies the return objective has potentially increased to 6.4%. Although the impact will vary by system, we would expect all systems to see current borrowing costs as higher than what they have borrowed at over the past 5-10 years.
If a health system wanted to both compensate for historical underperformance of its objective and, on a going-forward basis, target a higher return in line with its future cost of debt, reducing risk within the investment portfolio would likely no longer be as attractive.
Impact on days cash on hand
Here’s an additional consideration: Even if the stated return objective is framed around the cost of capital, if expenses are quickly rising, is it appropriate to consider expense growth in setting the return objective? Assuming operating margins are not strong enough to allow for inflows into the long-term pool, the investment returns must match expense growth to ensure that the contribution of the long-term pool to days cash on hand does not fall through time. If there is the desire to grow days cash on hand while expenses are increasing and operating profits are constrained, there could be the need to ensure that the return objective is meaningfully higher than expected expense growth.
The bottom line
How do you account for improving capital market expectations and the impact on the asset allocation process? For all health systems rising yields may mean that there is less of an expected return penalty from increasing the allocation to fixed income, but there is still no one-size-fits-all answer. The universal recommendation to all health systems is to step back and consider the role of the long-term pool for the enterprise. Before making asset allocation changes, there should be a robust conversation on what risk can be tolerated and what return should be targeted for the next 5 to 10 years. Take a quick look backwards—what has been experienced in the recent past? Then look forward at what the health system wants to target in the future.