Investor appetite for second-lien loans just keeps on growing despite concerns about limited or non-existent recovery in the event of default. The quest for yield is driving this growth as institutional players chase after first and second-lien loans, said John Brignola, director of Citadel Investment Group. He added that the market is predicting second-lien volume to grow 300% over last year.
But Brignola is concerned about second-lien recovery rates. "When we look at second liens, you have to wonder, given this growth, given the issuers interested in the product, what the default rates are going to look like and what the recovery rates are going to look like." Brignola highlighted Standard & Poor's recent evaluation of 51 transactions containing first and second liens. First-lien loans averaged a 2.9 recovery rating implying that lenders will recover 50-80% of principal in the event of default. The second-lien average recovery rating of 4.7 suggests that lenders can expect to recover less than 25% of invested principal, S&P states. "If first lien holders get 50-80 cents on the dollar recovery, it doesn't leave much room for second-lien recovery. It'll be interesting in the next couple of years," Brignola said.
Lenders have defended the purchase of second-lien loans by stating that the extra 500-600 basis points of yield, compounded over four years, can provide a cushion of 20-25% additional return over first-lien loans to absorb losses in the event of default, according to S&P. From a borrowers perspective, meanwhile, second-lien loans are a great way to tack on additional capital, said Brignola. Call flexibility is an additional feature of second-lien loans that makes them more attractive compared to a high-yield issue, mezzanine or subordinated debt.