U.S. demand for second-tier leveraged loans grows
NEW YORK (LPC) – US credit investors are increasing their risk by venturing into second-tier loans, which offer higher yields but lower recovery rates.
Second-tier loans, which have a second-tier right to assets in bankruptcy, are riskier than senior secured senior loans, but investors are more comfortable as the U.S. economy is strong and default rates remain low.
“We are in a positive credit environment and second quarter earnings have been very strong,” said Michael Nechamkin, co-chief investment officer and senior portfolio manager at Octagon Credit Investors. “It’s the kind of environment where you can take a little more risk. Second privileges have more risk, but you are going to be paid a lot more, often double or more on a spread basis. “
The 117 senior loans signed in 2018 to date offer average spreads of 772 bps over Libor, while the 1,183 senior term loans signed so far this year offer less than half the yield at 355 bp versus Libor, based on Thomson Reuters LPC data.
High yield bonds have a cumulative total return of only 1.26%, according to the Bank of America Merrill Lynch US High Yield Index.
“The returns in the first lien market have collapsed, so the ability to generate a return in the first lien market isn’t really there,” said Mike Terwilliger, portfolio manager at Resource Alts. “People want a floating rate, but if they go for first privileges, they can’t make it back.”
Second-tier loan issuance reached US $ 10.4 billion in the second quarter, compared to US $ 6.4 billion in the first quarter, according to data from LPC. There remains a small market at just 5% of the leveraged loan universe relative to senior term loan issuance.
“We’d rather take a little more risk in the structure buying a second lien from a business we really like rather than trying to buy a first loan from a business we don’t like,” said declared Nechamkin.
Second loans can also be difficult to obtain, as they are often pre-placed directly with funds instead of being heavily syndicated by banks.
“On good second-tier loans, it can be difficult to get paper because it’s usually a much smaller facility,” Nechamkin said.
Second-tier loans often have more favorable appeal protection, including firm appeal protection or a no-appeal period, compared to 101 indirect appeal protection on first-tier loans. Second-tier deals with stronger call protection often trade a few points against the issue price in the secondary market.
“For second privileges, we think hard call protection is an important part of the return because you can buy the loan at 98 or 99 and it can be traded at 103,” Nechamkin said.
The secondary performance of recent second-tier loans supports this theory. A US $ 3.1 billion buyout loan securing the purchase of Westinghouse Electric by Brookfield Asset Management includes a second tranche of US $ 325 million, which was sold at a discount of 99 and definitive call protection from 102/101. The second lien tranche opened in the secondary market at 101.5-102.5 on July 26, higher than the US $ 2.73 billion first lien trading level of 100.5-101.
Insurance software provider Applied Systems launched a US $ 1.5 billion dividend recapitalization in September 2017. The eight-year second loan is valued at 700 bps against Libor with a floor of 1% and a haircut of 99. The loan has a call-down protection of 102/101. and is now trading at 103-104 on the secondary market.
“Call protection won’t be there for prime privileges,” Terwilliger said. “You can refinance a first lien in the blink of an eye, but refinancing and revaluing a second lien is a much bigger business. “
Second-loan trading prices also rose as secondary prices stabilized after a lackluster second quarter. The SMi100, an index that tracks the 100 most widely held loans, rose to 98.49 on August 2 from 98.29 on July 2, the lowest level in 2018.
“We are seeing a balance between supply and demand for second privileges in the current environment,” said John Sherman, portfolio manager of DDJ Capital Management. “We don’t see an unhealthy level of investor demand leading to excessively risky new issues.”