| Subordinated debt 101 |
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| 26/12/2006 | |
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Michael Wilkins, Managing Director at S&P's Infrastructure Finance group and Paul Watters, Head of Bank Loan Ratings and Recovery at S&P in London, answer this week's 101 on subordinated debt. What is subordinated debt? Subordinated debt (sometimes known as second lien) has second ranking and priority over cashflows and security with respect to senior debt. It can be subordinated either contractually, structurally or legally depending on the transactions. Holders of subordinated debt would expect to come after senior debt in terms of receipt of cashflow for debt service and, in the event of insolvency, would also have the residual proceeds upon enforcement after the senior debt (assuming there is anything left). What are the advantages/expected returns and risks of investing in subordinated debt? How do you evaluate them? The advantages are clearly related to the higher yields earned on sub debt relative to senior debt. Investors often take a view that the returns are relatively higher commensurate to the extra credit risk from being subordinated. The return differentially can be anything between 200-300bp for a rating differential of around one rating category. Also, depending on the terms and conditions afforded to the sub debt, they could have relatively strong rights post default (see below). The key risk is that for a highly leveraged structure, the subordinated debt is often viewed as first loss capital (after equity, assuming there is any) and as such default risk is exponentially higher than for the senior debt. Also, in terms of recovery post default, in a highly leveraged structure there may not be any residual proceeds and hence sub debt recovery could be zero. How widely used is this instrument in institutional portfolios? CLO collateral managers, that represent about 70% of the institutional fund market, typically have the capacity to invest 15-20% of their portfolio into subordinated debt instruments. The extent to which they buy these assets very much depends on an assessment of the risk reward trade-off that incorporates an estimate of likely recovery in the event of default. At present many investors are limiting their investments to senior instruments and on a selective basis to second-lien where there is a junior mezzanine cushion sitting lower down the capital structure. Although it is difficult to generalise about Hedge Fund investment styles they are attracted to the low duration and spread margins available in the second-lien and mezzanine markets, and there are a good number that are looking to build a controlling interest in a debt class in anticipation of taking greater control as and when a company gets into distress. How have they performed in recent history and what is your outlook on the different types of subordinated debt? Performance for subordinated debt instruments has been extremely strong over the last three or four years as the incidence of defaults has been low. In today's market it is difficult to be so sanguine about performance looking forward as we expect defaults to trend gradually higher through 2007. In particular, we note that both second-lien and mezzanine loans feature in the more aggressively structured deals and our analysis indicates that recovery prospects for many of these loans would not be good. |
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