Collateralized loan obligation managers are starting to express interest in credit-default swaps on second-lien debt as a way to play different parts of the credit pecking order. As other spreads across corporate credit grind tighter, including buckets dedicated to these higher yielding second-lien CDS would allow managers to differentiate their deals from the crowded CLO field.
One trader said a manager recently requested pricing on CDS for a USD5 billion second-lien issue from HCA as his firm explores the possibility of including a short bucket of second-lien CDS in an upcoming deal.
CDS on secured debt are similar to the more common CDS on senior unsecured debt. In fact, if the assets securing the original loan change or are sold off, the contract will be changed to look much like a regular unsecured CDS contract. The buyer, however, may have rights above those of other unsecured holders and because they are tied to specific paper, second lien CDS are cheaper than CDS on unsecured debt. Bank of America credit strategist Glen Taksler estimated fair value of second lien CDS is approximately two-thirds the senior unsecured CDS spread.
Traders said CDS for second-lien notes are quoted on a handful of names, estimated to be between three and 10, with large outstanding second-lien notes and loans. Not enough second-lien CDS contracts trade to affect the prices of regular unsecured CDS, but this could happen if second-lien CDS trading volumes pick up and put pressure on the availability of deliverable obligations for unsecured CDS protection holders.
But loan experts said pricing the second-lien swaps is much more difficult than CDS on unsecured debt because there are more factors to take into account, such as the value of the collateral. Adam Cohen, lawyer and founder of Covenant Review, an independent covenant research firm, cautioned that understanding of collateral packages for second liens is limited. Collateral packages are subject to change based upon company actions allowed under the indenture and secured lender response and these can vary significantly from deal to deal.
As well as pricing difficulties, not everyone is convinced the instruments will fit well in a CLO. Jeff Kushner, head of execution at hedge fund Blue Mountain Capital Management in New York, said although including a short bucket dedicated to second-lien CDS would provide some marketing appeal, he believes it may not receive full benefit from the rating agencies.