The prospect of 8 percent yields can
drown out a lot of warnings when central bankers keep talking up
the need for easy-money policies to spur the economy.
That’s what investors in the junk-rated loan market were
offered by Formula One, two days after the Federal Reserve said
lax underwriting standards are setting up buyers of the debt for
losses due to higher defaults. In exchange, investors of the CVC
Capital Partners Ltd.-controlled racing company’s loans would
accept a lesser claim on assets and weaker protections that may
lead to greater losses if Formula One ever defaults.
While the Fed is trying to contain the risk-taking
unleashed by its own extraordinary stimulus, investors are
showing an increased willingness to sacrifice safeguards for
higher returns as benchmark interest rates remain close to zero
for a sixth year. That’s allowed some of the least-creditworthy
borrowers to raise $20.6 billion of the junior-ranked debt known
as second-lien loans this year, eclipsing 2013′s record pace.
“When the Fed tells me they are concerned about it, I know
it’s time to leave,” William Larkin, a money manager who
oversees more than $500 million at Cabot Money Management, said
in a telephone interview from his office in Salem,
Massachusetts. “I am cutting my exposure.”
Issuers of second-lien debt have reduced their borrowing
costs by more than a percentage point this year, even as the
yield on first-lien loans, which generally provide the highest
claims on a company’s assets in a default, has increased.
Formula One is offering to pay 6.75 percentage points to 7
percentage points more than the London interbank offered rate on
the $1 billion covenant-light junior loan, with a one percent
minimum on the lending benchmark, Bloomberg data show. Libor (US0003M),
the rate at which banks say they can borrow from each other, was
set at 0.23 percentage point yesterday.
The company’s second-lien debt, along with a $1 billion
first-lien financing is being used to refinance and fund a
distribution to shareholders, according to a July 17 report from
Moody’s Investors Service.
Moody’s graded Formula One’s second-lien loan Caa2, a level
assigned to debt considered of poor standing and having very
high credit risk. Claudia Gray, a CVC spokeswoman who works at
Brunswick Group in New York, said the company declined to
comment about its offering of second-lien loans.
Investors are being paid as much as 3 percentage points in
extra yield to hold second-lien debt instead of first-lien
loans, with the average yield of 9 percent at the end of June,
according to Standard amp; Poor’s Capital IQ Leveraged Commentary
and Data. At the start of the year, the cost was 10 percent.
First-lien borrowings yield an average 5.3 percent from 4.8
percent at the start of 2014.
Companies, especially those controlled by private-equity
firms, prefer second-lien loans over junk bonds as they have
fewer restrictions that prevent them from being paid early,
according to Tim Broadbent, the New York-based head of Americas
leveraged loan syndicate at Barclays Plc.
“If the issuer doesn’t value pre-payability, they would do
bonds all day, every day,” he said.
In a report published July 15 by the Fed as part of Chair
Janet Yellen’s semi-annual testimony to the Senate Banking
Committee, the central bank said it’s engaged in “strong
supervisory follow-up” to guidance given to banks in 2013 to
improve their underwriting standards for high-yield loans.
The market for loans rated below investment grade may be
vulnerable to deeper losses than in past cycles because
companies will struggle to refinance debt cheaply as rates rise
from record lows, Martin Pfinsgraff, the top large-bank
supervisor at the Office of the Comptroller of the Currency,
said this month in an e-mailed response to questions from
“We’ve heard regulators voicing concern about cov-lite
loans,” Beth MacLean, a money manager at Newport Beach,
California-based Pacific Investment Management Co., said in a
telephone interview. “Second-liens are of greater concern as
they are more risky than covenant-light first-lien loans.”
Covenant-light borrowing typically lack standard
protections for lenders such as limits on debt relative to
earnings. A record $314.8 billion of such debt were arranged in
2013 and more than $165 billion have been issued this year, data
compiled by Bloomberg show.
Most borrowers with second-lien loans don’t have any lower-ranking debt, which may mean recovery rates will be only
marginally better than those offer by unsecured bonds in a
default, according to a report published this month by Moody’s.
“We are seeing more deals where the second-lien loan is
structured as the junior debt as opposed to having unsecured
debt below them,” John Puchalla, a senior vice president at
Moody’s said in a telephone interview. “Even though they are
secured, if the company ends up defaulting, they would be the
first creditor class to absorb losses.”
Projections for recoveries from existing second-lien debt
in case of a default are as low as 25 percent, according to a
January Moody’s report written by Puchalla. That compares with a
historical average of 52 percent.
“Second liens are a much riskier segment of the market
with less liquidity,” Pimco’s MacLean said. “In a market where
investors are being pushed to take more risk to generate
returns, some are willing to take on more risky investments like
To contact the reporter on this story:
Sridhar Natarajan in New York at
To contact the editors responsible for this story:
Shannon D. Harrington at
Faris Khan, John Parry