Investors seeking higher yields in a still low-yield environment are putting more money lower down in the capital structure in 2021—in “second-lien” debt that places them further back in the line to be repaid in case of default. The volume of second-lien issuance in 2021 as of early August has already eclipsed the total issuance in both 2020 and 2019, according to data from Refinitiv LPC.
According to Dan Zwirn, CEO at Arena Investors, it’s “very logical” that many investors are looking deeper into the capital stack for yield now, because the investments, though “speculative” in Zwirn’s view and with lower than typical absolute returns, still may look attractive on a relative basis. Zwirn issues a caution, however.
The average yield for first lien loans with a three-year term in the third quarter through August 11 was 4.7%, while the average yield for like-termed second-lien loans in the same period was 7.61%. That difference of 2.91 percentage points was the smallest since Refinitiv began tracking second-lien data a decade ago.
While Zwirn understands the motivation for investors to pull yield from second-lien loans in this environment, he notes that the risk of doing so can easily be underestimated, and that to make the risk appropriate, a lender must not allow “weak covenants and inter-creditor terms.” Otherwise, Zwirn says, the lender is relying only on “an ephemeral notion that something’s there in either assets or creditor rights to define the lender’s position”—not necessarily superior to an outright unsecured loan, Zwirn says.