Finance and Business Strategy

Robert Turner: Avoiding a bond covenant default takes aggressive action from a health system borrower

March 30, 2023 10:51 am

Not-for-profit hospitals and health systems have faced an increasingly difficult operating environment since inflation began to grow in mid-2021.

Last year was particularly hard, beginning with a new wave of COVID-19 infections caused by the omicron variant, and followed by mounting expenses, staffing shortages, rising interest rates and investment losses. As a result, Kaufman Hall estimated that more than half of hospitals and health systems nationwide ended 2022 with a negative operating margin and substantial reductions in liquidity. Recent data suggests those same dynamics persist into early 2023.a

These operational and financial difficulties have put many organizations at risk of breaching debt covenants, such as debt service coverage ratio or minimum days cash on hand. The devil is in the details, and those details may be located in several places, including not only in the master trust indenture (MTI) but also in separate covenant agreements with banks or other lenders.

Organizations can best address this issue through a process that involves three broad steps.

1  Understand the implications and risk of a covenant challenge

The first, and critical, step is understanding which covenants are at risk and how those covenants work. This includes completing a full inventory of covenants across the organization’s debt portfolio, identifying which covenants may be at risk of a breach and detailing the processes for remediation if a breach occurs.

This analysis of covenants may provide some good news. In certain instances, for example, a breach of a covenant may not constitute a default unless the organization fails to meet the covenant’s threshold requirements for two consecutive years. That good news may come with conditions, however, including restrictions on actions that limit management options at a time when many organizations need the greatest possible flexibility in managing their resources.

Year-one requirements and restrictions include the following:

  • A required consultant call-in to report on performance improvement opportunities that could help avoid default within the following year with stipulations that management follows those recommendations
  • Restrictions on the ability to merge with another organization, absent evidence that the merger would help avoid default
  • Limits on additional borrowing unless the organization can demonstrate its ability to meet certain thresholds for maximum annual debt service (MADS) or debt service coverage
  • Limitations on the ability to sell, lease or dispose of property, again unless the organization can demonstrate it will meet thresholds for MADS or debt service coverage

A borrower’s most recently available audited financial statements are often the basis for covenant testing. As a result, once an audit is filed showing performance below covenant levels, cures generally involve one of the following:

  • Filing audited financial statements that demonstrate sufficient performance in a future year
  • Seeking waivers from investors
  • Restructuring the debt that imposes these restrictions

Another strategy is to accelerate any of these activities before audited financial statements are published, thereby demonstrating insufficient financial performance.

There is more to say about each of these topics beyond the scope of this discussion. Indeed the legal language, facts and circumstances for a particular borrower will all have a bearing on what each will or will not be able to do. If any of these topics is on the docket for the coming year, it will be important to consider the covenant implications related to such activities.

2  Accelerate performance improvement efforts

If it appears that one or more covenants is at risk of a breach, organization leaders must move quickly to assess revenue enhancement and expense reduction opportunities to avoid or mitigate the impacts of a breach. In particular, if a consultant call-in is a requirement in the event of a year-one failure to meet a covenant threshold, leadership should consider beginning that process before the requirement takes effect. The feedback we receive from buy-side investors is very much in support of engaging consultants early in the process.b

A year-one trigger of required actions or restrictions will leave little time for financial improvement before a year-two default occurs; initiating the consultant call-in process and preparing the report will make that time even shorter. If a year-one trigger is likely, the organization may need to develop and quickly implement a performance improvement plan, understanding that some elements of the plan will take more than 12 months to realize savings. Leadership may need to maximize savings within the time frame stipulated by the covenants.

An early start on performance improvement may also identify opportunities for restructuring debt, selling real assets, drawing on a bank line of credit or taking other actions that may become difficult to perform if the organization fails to meet its year-one threshold requirements.

3  Review financial and communication planning

The risk of a covenant breach also should prompt a review of the financial plan. The financial plan will help give leadership clarity on the size of the gap between the plan and actual performance. Financial planning expertise will also be required to run various scenarios around projected volume, payer trends and turnaround plan sensitivities that will help leadership gauge what will be required to avoid a default.

Leadership should also develop a communications plan for key stakeholders — including board members, creditors, rating agency analysts and investors — to apprise them of the situation, the underlying causes of the problem and the actions being taken to resolve them. Communication should begin as soon as leadership is aware of a problem, including regular updates as plans to fix the problem are enacted.

Finally, working with legal counsel, leadership should pursue any options for remediation with creditors, including forbearance, waiver or amendment of the covenant. Creditors generally want to be supportive of efforts that help ensure that their investment will be repaid, but their support will be easier to obtain if the organization has demonstrated its commitment to taking the issue seriously and acting on it promptly.


A review of covenants might reveal that the organization has time before an event of default occurs. The worst outcome is for leadership to ignore the problem or hope that it will resolve itself. That time must be used wisely to avoid a scenario that’s unpalatable to the organization and its creditors. 


a.  Swanson, E., National Hospital Flash Report, Kaufman Hall, Feb. 27, 2023.
b.  Goldstein, L., and Wareham, T., “Buy-side perspectives on not-for-profit healthcare,” Kaufman Hall, Nov. 15, 2022.

Key terms overview

The following terms are likely to come up in discussions of how to prevent or respond to debt covenant breaches or bond defaults.

Debt covenant. Restrictions or requirements placed on a borrower by lenders (e.g., banks, creditors, investors) in a loan document or bond issue. Covenants help lenders mitigate the risk that the borrower will be unable to fully repay the debt. An example is a debt service coverage covenant, which requires that the borrower maintain sufficient cash flow to pay the principal and interest on its outstanding debt.

Breach. Failing to meet the requirements of a covenant (e.g., not generating sufficient income to meet principal and interest payments) or acting in a way that violates a covenant (e.g., selling a major asset without the lender’s consent).

Default. A covenant breach can be an “event of default,” which entitles the lender to pursue remedies specified in the loan documents, including acceleration of the borrower’s obligation to repay all of the outstanding debt.

Master Trust Indenture (MTI). A document that establishes a consistent framework for covenants, terms and security for debt issued by members of an obligated group (e.g., affiliated hospitals within a health system). Advantages of an MTI include the ability of obligated group members to pool their credit strength and to issue additional debt on parity with existing debt.

Remediation. The process of remedying or “curing” an event of default. Lenders will have a range of remedies they can pursue. Examples include waiving or amending a covenant, requiring a consultant call-in and report that outlines a performance plan for bringing the borrower back into compliance or accelerating payment on the outstanding debt.


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