Mal-Investment Mania - The Second-Lien Scramble Is Back

Tyler Durden's picture

The zombification of corporate America is nowehere more evident than the yield-starved demand that has enabled companies with the lowest of the low credit ratings to raise debt capital and stay alive far beyond their 'natural' lifespan. As WSJ reports, investors are gobbling up some of the riskiest debt from junk-rated European companies at the fastest pace in years. The riskiest tranche of that debt - so-called second-lien, or junior, loans - amounts to $3.3 billion, almost double the amount raised at the same stage last year and the most over the same period since 2007. The reason is simple - Central Banks - "If you have more demand than supply then you end up with a loosening of terms and potentially more leverage and more aggressive structures."

 

As WSJ reports, investors are gobbling up some of the riskiest debt from junk-rated European companies at the fastest pace in years.

Companies with lower credit ratings have raised $186 billion in junk loans so far this year, according to Dealogic. The riskiest tranche of that debt—so-called second-lien, or junior, loans—amounts to $3.3 billion, almost double the amount raised at the same stage last year and the most over the same period since 2007.

This is not simply a dash for trash - this is the absolute lowest of the low in the capital structure...

If a borrower goes bust, junior lenders are only repaid if some other, higher-ranking lenders, get all their money back. Only unsecured creditors and shareholders are further down the queue. Companies also get better terms—junior loans are less restrictive when it comes to taking on additional leverage than senior debt, while borrowers get more flexible repayment options than bonds.

 

In exchange for the additional risk, investors get a better return. Interest rates on junior loans are typically 3.5 percentage points higher than senior loans, bankers say.

The reason is clear...

The rise in junior-loan issuance comes as loose monetary policy from central banks has depressed yields, pushing some investors into riskier assets that offer higher yields.

 

"If you have more demand than supply then you end up with a loosening of terms and potentially more leverage and more aggressive structures," said Elissa Johnson, a fund manager at Henderson Global Investors, which oversees around £1 billion ($1.66 billion) of loan assets.

 

Dealogic data show that more than half the loans that include junior debt have been used for acquisition financing, with a smaller proportion financing dividend payments.

And it's not slowing down - yet...

Meanwhile deal sizes are getting larger too. Last month, Spanish private hospital operator IDCSalud raised €2.15 billion in junk loans, €350 million of which was in junior debt, the largest junior deal from a European company in three years.

 

"We're seeing more and more requests from companies for these type of deals,"

Oh - and by the way - the risk is enormous...

Losses on junior loans can be steep if a company fails. The average recovery rate on defaulted junior loans in Europe between 2003 and 2013 was 36%, according to Standard & Poor's. That compares with 76% on senior loans, S&P data show.

So be sure that extra 350bps of yield covers your 64% capital loss potential...

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This is 'mal-investment' writ large, and at least as bad as during the 2007 bubble.

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The only thing is... credit investors are getting antsy again...