Second lien bank loans have been more frequently appearing in new CLOs, especially as managers look for higher yielding collateral during this period of historic tights.
Second liens offer between 200 and 500 basis points of pickup over traditional senior secured bank loans, said one CLO collateral manager. Market players have mixed feelings about the trend, especially as some of the first deals to include second liens were differentiating.
"If [second lien loans] offer relative value in an individual transaction, and it's appropriately priced, then it makes sense," said one CLO collateral manager. "If someone's doing it just to make minimum spread requirements, which was not the stated intention, then that's not a good thing."
Tightening collateral spreads and diminishing supply, as a general rule, are not particularly positive for CDOs in ramp-up mode. "In an overheated market for loans, loan quality is going down, and some people claim that CLOs are buying lower-quality loans," said one researcher at a bank with an active CDO desk. "I think the lack of collateral has driven people into the second lien loans."
Second liens began slipping into some 2003 vintage CLOs, sometimes receiving the same recovery assumptions as first priority loans.
Rating agencies became aware of the trend during the second half of last year, and, in response, some have begun revising criteria.
In particular, last year Moody's Investors Service began differentiating between the two. The agency now requires that second lien loans be placed in a separate carve-out, with downward adjusted recovery assumptions.
Fitch Ratings also said it has noticed the trend of second liens slipping into CLOs and it has begun to assign lower recovery rates to the loans.
"We are aware that some deals have tried to treat second priority loans the same as first priority senior secured loans," said Mark Froeba, vice president/senior credit officer in the derivatives group at Moody's.
"We've responded by requiring that the definition of senior secured loan' explicitly exclude second priority loans unless the rating on the second priority loan is at least equal to the loan obligor's senior implied rating from Moody's.
As a result, all second priority loans will be treated like unsecured loans for recovery-rate purposes except where the rating on that loan warrants better treatment."
Moody's senior implied rating describes the hypothetical rating of a single class of debt issued by a hypothetical entity made up of all the separate entities in a corporation. This rating is generally lower than senior loans are rated.
Moody's amended assumptions translate as follows: at two notches above the implied rating, second priority loans score 45%, versus 60% for senior secured first lien loans; at one notch above implied, second liens score 42.5%, versus 50% for first liens; at par with implied, second liens score 40%, versus 45% for first liens.
For one notch below implied, second liens score 30%, while first liens score 40%; for two notches down, second liens score 15%, while first liens score 30%; for three or more below implied, second liens score 10%, while first liens score 20%.
Origination of second lien loans, which fall somewhere between senior secured and mezzanine loans, has increased over the last year. Volume picked up beginning in mid-2003 and was especially robust this past quarter, with lead arrangers launching syndication of two or more second lien tranches a week. Second lien loans provide an alternative to issuers who'd rather complete a cheaper second lien deal than a high yield debt offering, market players said.
One source was concerned that there is no clear definition for the second liens (thus Moody's defines them as specifically not senior secured). "If there's actually hard collateral, like real estate or equipment, that's one factor," the source said. "If it's just called a second lien but it's really a cashflow loan, that's a problem."
So far this year, about $5.1 billion in loan-backed CDOs have priced.
Two new CLOs have entered the pipeline over the past few weeks, including a $1 billion deal led by UBS for American Express Asset Management (Centurion VII), and a $300 million deal led by Bear Stearns for Mountain Capital Management (Mountain III).