Second-lien loans gain popularity but could disappoint in default situation, S&P says

By Sara Rosenberg

New York, Oct. 12 - Second-lien loans make up the fastest-growing segment of the leveraged loan market, but investors may be disappointed by recoveries in an event of default, according to a new report by Standard & Poor's entitled "Second Liens: Secured, Subordinated, or Both?"

During the first nine months of 2004, second-lien loan volume jumped to $9.9 billion, three times more than 2003's full-year total, with the increase attributed to low default rates and strong investor demand. In fact, according to the report, the second-lien loan has developed a broad following among traditional institutional accounts, such as collateralized loan obligations and loan mutual funds, and hedge funds.

"After a brief flirtation with second-lien loans in the mid-1990s, these facilities fell out of favor after the Russian debt crisis caused investors to adopt a more cautious tone," said Steven Bavaria, S&P's vice president and head of Loan Rating, in a release. "But after default rates fell precipitously in 2003, arrangers rolled out these facilities to help finance issuers struggling with liquidity problems. By 2004, the market had accepted second-lien loans to finance a wide array of transactions, including acquisitions and recapitalizations."

However, based on the 51 recovery ratings S&P has assigned to second-lien loans so far this year, investors may get little comfort from recoveries in a default scenario, S&P said, as the rating agency has found that in 88% of the loans rated, the first-lien debt was expected to recover less than 100%, leaving no recovery for second-lien holders.

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