Second-lien pricing may not fully recognize investors' risk of loss, S&P says

By Jennifer Chiou

New York, Aug. 8 - Standard & Poor's said in a report that investors in second-lien loans should contemplate pricing to ensure they are fully taking into account the possible losses associated with potential defaults.

In the report based on its third-annual second-lien portfolio review, S&P noted three conclusions relating to the risk/reward ratio for second-lien loan investors:

• Transactions continue to include features that will likely afford second-lien lenders stronger negotiating leverage and stronger recovery prospects than would be allowed with either "silent seconds" or "absolute priority;"

• Lenders should not expect that second-lien debt likely will receive a static asset-class recovery; and

• Second-lien pricing may not fully recognize lenders' risk of loss-given-default relative either to the single asset or to a hypothetical portfolio of both defaulting and solvent second-lien debt.

"If the credit cycle has entered a stage in which defaults are increasing, then it is also likely that a substantial portion of those defaults would include second-lien debt," said S&P recovery analyst Steve Kerr.

"While lenders generally seek increased margins when credits deteriorate, they are typically a reaction to the increased probability of default of the borrower.

"Unfortunately, it does not appear that lenders are also seeking sufficient pricing at origination - or increased pricing along the borrower's path to default - that sufficiently compensates lenders for the risk of increased loss-given default associated with second-lien debt."

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