Moody's finds capital position, family performance key to second-lien recoveries

By Angela McDaniels

Seattle, Sept. 20 - A historical review by Moody's Investors Service found that second-lien recoveries averaged 72.1% when an issuer's capital structure included unsecured debt, but only 40.1% when the second-lien debt lacked this cushion for absorbing loss.

Overall, the agency found second-lien debt recoveries to average 60.5%, about 7% higher than for unsecured debt similarly positioned in the capital structure of other defaulting issuers.

The study also found that lien subordination invariably holds - that is, within one defaulting issuer family, first-lien recoveries were always higher than second-lien recoveries, except in instances when both recoveries were 100%. And, except when both had zero recoveries, second-lien recoveries were always higher than unsecured debt recoveries.

A defaulted issuer's capital structure, along with the level of recovery for its corporate family as a whole, principally determines the level of recovery on defaulted second-lien debt, according to Moody's.

"Investing in second-lien debt - particularly if it is the most junior ranking obligation within a capital structure - does not assure protection against loss in a default," Moody's assistant vice president and analyst John Puchalla said in an agency news release.

"Because a number of second-lien obligations issued in the last few years have no debt cushion, recovery experience going forward could be considerably less than the 60.5% historical experience, and likely more closely aligned with historical average recoveries for unsecured creditors."

Puchalla said that in the study considerable variation existed in recoveries at both the first- and second-lien instrument level and he cautioned against broadly assuming continued realization of the 60.5% historical second-lien recovery average.

The agency said family recovery is also an important driver of second-lien recovery, given the principal that "a rising tide lifts all boats," but this is more difficult to predict in advance of default than the position of debt in an issuer's capital structure.

Russ Solomon, senior vice president and chairman of Moody's standing committee on priority of claim and notching practices, emphasized further that collateral valuation is an important component of analysis for second-lien obligations because it is integral to determining second-lien debt's position within a capital structure.

"In particular, deficiencies in collateral coverage can relegate some or all of the second-lien obligation to an unsecured claim in bankruptcy," Solomon noted.

The study examined the 72 issuers with second-lien debt in the capital structure. Recovery was defined as the value received, discounted at the stated coupon rate as a percentage of principal at the time of the last payment. Moody's said it plans to look in the future at recoveries as a percentage of principal at origination.

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