Increased consolidation coupled with higher issuance of corporate debt are among the factors that could alter the credit profile of the healthcare sector, the second-largest sector weight in the S&P 500.

“Heightened M&A and accelerating investment-grade bond issuance by US healthcare companies is being accompanied by a shift in credit quality,” said Fitch Ratings in a note out Monday. “The outlook for the sector remains intact due to solid underlying demand growth for most types of healthcare products and services but downward rating migration is occurring as the sector is consolidating and companies are funding large strategic acquisitions.”

The Health Care Select Sector SPDR (NYSEArca: XLV), the largest healthcare exchange traded fund, is up about 6% year-to-date.

XLV allocates about two-thirds of its combined weight to pharmaceuticals and biotechnology stocks. There are other catalysts to consider, including that the U.S. economy is moving into the late-cycle phase, overall growth may slow and signs of an economic slowdown could pop up. Consequently, investors may also turn to defensive sectors that are less economically sensitive, such as healthcare.

Health Industry Challenges

“Pricing pressure, regulatory changes, pressure from activist investors and still historically low interest rates will encourage more horizontal M&A and deals that vertically integrate the sector,” said Fitch. “We view M&A and investor appetite for high quality paper, particularly during the late stages of the economic cycle, as major contributors to the rise in investment-grade bond issuance. However, prospects of enhanced cash flow generation and greater efficiencies of scale are not fully offsetting increased leverage and this is altering the long-term credit risk profile of the sector.”

Data suggest healthcare companies, including some residing in XLV and rival healthcare ETFs, are boosting issuance of corporate bonds.

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