Changing pools in collateralized loan obligations could lower recovery rates compared with senior debt. CLOs are increasingly allowing larger buckets for second-lien loans, which are subordinate to first-liens in their claim on collateral in case of bankruptcy, according to Gyan Sinha, head of asset-backed security and collateralized debt obligation research at Bear Stearns.
The number of CLOs allowing second-liens shot up to 78% in the first half of this year from around 42% in 2004. In addition, the average bucket size of second-lien loans has increased to 10% from 7.4%.
Second-lien loans are increasingly sought as CLO collateral because issuance has increased and the loans yield more than their first-lien counterparts. Issuance of second-lien loans rose to $9.5 billion in the first half of 2005, already close to last year's total issuance of $11.9 billion. And second-liens averaged 532 basis points over LIBOR, compared with first-liens' 264bps spread.
Sinha cautioned there have only been two second-lien defaults to date and the economic cycle has not yet turned. "In the near-term, the economy seems robust and the number of defaults does not seem as if it will increase dramatically," he noted.