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West Penn Allegheny Looming Default No Bellwether: Muni Credit

The $100 billion market for high-yield municipal debt is rallying the most in three years in the face of the potential bankruptcy of the biggest tax-exempt junk issue since at least 1990.

West Penn Allegheny Health System, a hospital group in Pittsburgh with $726 million of debt below investment grade, is struggling with deepening losses and falling revenue. There is “a high likelihood” the provider will seek bankruptcy protection or restructure its bonds, even as it discusses affiliating with one of the nation’s 10 biggest health-insurance companies, Moody’s Investors Service said last week.

Securities of West Penn have lost about 35 percent of their value since their sale in 2007, data compiled by Bloomberg show. Meanwhile, speculative-grade munis are earning the most since 2009. With tax-free interest rates at 45-year lows, high-yield munis will extend their rally even if West Penn fails to repay investors in full, said Susan Courtney, a managing director at Prudential Fixed Income in Newark, New Jersey.

“Investors in the muni high-yield space are aware of what’s going on with West Penn,” said Courtney, who helps manage $1.8 billion in tax-exempts, including West Penn bonds. “In this low-rate environment you have the search for yield, so the lower-rated credits are performing better.”

2012 Reversal

Muni investors have poured $9.7 billion into high-yield funds this year, compared with $2.6 billion of withdrawals in the same period of 2011, Lipper US Fund Flows data show. The hunt for yield in 2012 has lowered borrowing costs for financially stressed issuers from California to Puerto Rico.

Gains in the $3.7 trillion muni market accelerated in the past two weeks amid speculation that income-tax rates will rise as part of trimming the federal deficit. While munis have earned 8.2 percent this year, high-yield has banked 17 percent, the most since 2009, according to Standard & Poor’s. Debt backed by hospital and health-care revenue has earned about 11 percent.

Yet West Penn, which admitted almost 56,000 patients in fiscal 2012, has been left out of the rally. Bonds due in 2040 traded at an average of 65.64 cents on the dollar today, down from 101.8 cents when they were issued in May 2007, data compiled by Bloomberg show. The average yield on today’s trade was 8.66 percent, compared with 5.15 percent at issue.

West Penn has made no determination on a bankruptcy filing, Kelly Sorice, a spokeswoman, said in an e-mail.

Always Speculative

The company’s tax-exempt revenue deal was initially rated Ba2 by Moody’s, two levels below investment grade. The debt, which doesn’t have bond insurance, is now eight steps lower at Ca after Moody’s downgraded the system last week.

The offer was the largest tax-exempt junk deal since at least 1990, Bloomberg data show. Larger issues backed by tobacco revenue were sold with investment grades and are now junk, said Daniel Solender, who helps manage about $17 billion of munis bonds, including West Penn, at Lord Abbett & Co. in Jersey City.

The market for tax-exempt munis ranked below investment grade tallies about $100 billion, not including unrated issues, according to Peter DeGroot, an analyst at JPMorgan Chase & Co.

The buying has shrunk the extra yield that investors demand to hold 30-year munis rated BBB, two steps above junk, to 1.7 percentage points, close to the smallest since 2008, Bloomberg data show. The 10-year average is about 1.4 points.

More Room

The longer-term trend shows “there still would be room” for more gains, Courtney said.

Investors still shouldn’t expect a repeat of this year, said Tim Pynchon, who helps manage $3 billion of high-yield munis at Pioneer Investment Management Inc. in Boston. Returns in 2013 may be limited to 8 percent or less, he said.

“You can’t anticipate that we’re going to see a year like this next year, because much of the risk premium that should be in place is now being eliminated,” Pynchon said.

West Penn terminated an affiliation agreement with Pittsburgh-based Highmark Inc. in September partly because the latter demanded that West Penn restructure its debt through bankruptcy, the system said on Sept. 28. Officials from both sides met last week to discuss a potential affiliation after a Nov. 9 court ruling prohibited West Penn from seeking other partners, according to Sorice, the West Penn spokeswoman.

‘Best Interests’

“Highmark and WPAHS continue to believe that an affiliation between them is in the best interests of both organizations and of the greater community,” the groups said in a statement issued Nov. 12.

Any partnership would require approval from the Pennsylvania Insurance Department. West Penn encompasses five hospitals, including Allegheny General Hospital, with 1,695 physicians.

West Penn had operating losses of $113 million and $75 million in the past two years, according to Moody’s. The system has an unfunded pension liability of $279 million. It competes with the University of Pittsburgh Medical Center, the region’s largest health system.

West Penn was formed in 2000 to bring the five hospitals under one company after Allegheny General Hospital’s parent filed for bankruptcy in 1998.

“This is a situation that’s been difficult for a long time,” Solender said.

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