The uncertainty created by the Clinton administration's announced health-care reform plan has created substantial turmoil in the stock market, with shares of drug companies, insurers, and other firms servicing this $840 billion sector of the economy trading down substantially since the start of the year.

To date, investor interest has focused almost exclusively on the equity markets. Yet to the extent that the Clinton plan places new financial burdens on hospitals, and on the states themselves, it will also have a significant impact on the market for tax-exempt debt. This impact, while generally acknowledged, is difficult to quantify and, perhaps as a result, has not yet been discounted by the municipal markets.

Intuitively, investors realize that hospital issues will likely be first to feel the pinch, though even here there has been little or no movement in prices. In addition to hospitals, there's a better than even chance that general obligation debt will also come under pressure as states are forced to reallocate scarce financial resources to cope with rising health-care costs.

The reason for this potentially broad-based impact is simple: As health-care expenditures have grown to account for an increasingly large portion of the nation's gross domestic product, so they have also come to represent a proportionately larger portion of state spending.

In 1960, spending on health care accounted for about 5.3% of GDP. according to data compiled by the Health Care Financing Administration. By 1992, that figure had nearly tripled to 14%. At the state level, health-care spending represented 16.3% of the total in 1990, up from 1.5% in 1965.

States continue to be pressured financially by this upward spiral, with Medicaid costs remaining the single most onerous and the fastest-growing component. Between 1990 and 1991, Medicaid expenditures jumped an incredible 31%, to $94.5 billion, according to data compiled by the Health Care Financing Administration. Of that, the federal government paid $52.5 billion, while the states' share amounted to the remaining $42 billion.

Under the Reagan and Bush administrations, more and more responsibility for underwriting health-care costs was pushed onto the states, one decentralization trend that the Clinton administration is likely to embrace. Healthcare costs as a percentage of state and local revenues have soared from 7.5% in 1965 to 16.3% in 1990, according to the Health Care Financing Administration. As a result, the financial burden footed by the states grew in both absolute and relative terms - an unhappy trend that will probably continue.

At the same time that expenses are going up, the states' ability to impose new levies will be severely limited by the tax proposals President Clinton has on the table. States that have not already put in place a mechanism to address a potential shortfall in Medicaid-related revenues may well have missed the chance to do so.

Oregon, for example, recently failed to put in place the state's first-ever sales tax. Now the federal government is proposing a national sales tax, or a value-added tax, which would effectively kill any future possibility of enacting a similar tax within the state. For Oregon and other states caught in the same trap, the net result will be increased pressure on revenues, reduced financial flexibility, and, ultimately perhaps, lower coverage ratios.

How should municipal bondholders respond to health-care reform? As noted, the principal reaction so far has been indifference; the market has rallied in line with the general decline in interest rates, while hospital issues have proven to be especially attractive to yield-hungry investors. However, as the details of the Clinton plan begin to emerge next month, and the fiscal realities of the proposal begin to sink in, the market will be forced to confront this new reality.

The impact will be felt first among hospital issues, spreading to state GOs, and it will be felt disproportionately by the handful of states that in 1990 accounted for one-third of overall Medicaid expenditures: New York with 18.3%, California with 10.1%, and Pennsylvania with 4.5%.

While no one can say what health-care reform will look like, it almost certainly will affect the financial markets in unexpected ways. Completely eliminating health-care risk from a portfolio is probably neither possible nor desirable. However, investors should make certain they are being adequately compensated not just in areas of obvious risk, like hospital issues, but in GOs as well.

Robert J. Froechlich is first vice president and director of fixed-income research at Van Kampen Merritt Inc. in Oakbrook Terrace, Ill.

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