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Riskier Junk-Loan Demand Soaring Like It’s 2007: Credit Markets

Riskier Junk-Loan Demand Soaring Like It’s 2007
Pedestrians walk past a Rite Aid Corp. store in Oakland, California. Rite Aid lowered the rate on a $500 million second-lien loan it’s seeking to tender for second-lien notes, according to a person with knowledge of the transaction. Photographer: David Paul Morris/Bloomberg

Junk-rated borrowers from Rite Aid Corp. to Atkins Nutritionals Holdings Inc. are raising a riskier type of loan that offers a lesser claim on their assets at a pace last seen before the financial crisis.

Second-lien loan issuance has climbed to $17.1 billion this year, versus $18.6 billion in all of last year and on pace to surpass the record $28.7 billion issued in 2007, according to data compiled by Bloomberg. Rite Aid, the third-largest U.S. drugstore chain, reduced the interest rate on its $500 million loan due to increased investor demand, while dieting company Atkins raised $355 million in loans, including second-lien debt, to fund a dividend.

Investors are turning to the junior-ranking loans that would shield them from an increase in interest rates and offer more protection than bonds, which have been pummeled as speculation increases the Federal Reserve will pare back its unprecedented stimulus. Second-lien loans have fallen just 0.3 percent since Fed Chairman Ben S. Bernanke said the central bank could reduce its asset purchases if the economy shows sustained improvement, while junk bonds have lost 9 times more.

“A second-lien loan is effectively a high-yield bond in disguise,” John Bell, who co-manages $4.4 billion in fixed-income assets at Loomis Sayles & Co. in Boston, said in a telephone interview. “There’s notably more yield and low-default expectations in general on the demand side.”

Second-Lien Premium

The extra interest that investors demand over the London interbank offered rate to hold second-lien debt fell to 7.7 percentage points on June 6, from 9.1 percentage points at the start of the year, according to Standard & Poor’s Capital IQ Leveraged Commentary and Data.

First-lien loans, which generally provide the highest claims on a company’s assets in the event of a default, paid an average 3.84 percentage points more than Libor last week, according to S&P LCD. Three-month Libor was set at 0.27 percent yesterday.

The trailing 12-month leveraged loan default rate declined to 2.5 percent last month, from 2.9 percent in April, according to a June 10 Moody’s Investors Service report. That compares with 9.4 percent in August 2009, according to the New York-based ratings firm.

“In a benign default environment investors are willing to step down the capital structure,” Scott Baskind, a New York-based senior money manager for Invesco Ltd.’s bank loan group, said in a telephone interview. “Investors have been looking for risk assets that would provide juicier yields. The demand side of the market remains very strong.”

Default Swaps

Elsewhere in credit markets, a gauge of U.S. corporate credit risk fell even as consumer confidence dropped this month and industrial production remained unchanged.

The Markit CDX North American Investment Grade Index, a credit-default swaps benchmark that investors use to hedge against losses or to speculate on creditworthiness, decreased 0.5 basis point to a mid-price of 81.7 basis points at 12:30 p.m. in New York, according to prices compiled by Bloomberg. The index has fallen from a two month closing high of 87.5 basis points on June 12.

Investors are trying to gauge when the Federal Reserve will scale back its $85 billion monthly bond purchases, known as quantitative easing. Fed Chairman Ben S. Bernanke will announce the central bank’s policy on June 19 after the two-day Federal Open Market Committee meeting.the cost of protecting corporate bonds from default in the U.S. fell from a two-month high.

Morgan Stanley Bonds

The credit-swaps index typically falls as investor confidence improves and rises as it deteriorates. The contracts pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

Bonds of Morgan Stanley were the most actively traded dollar-denominated corporate securities by dealers today, accounting for 4.2 percent of the volume of dealer trades of $1 million or more, according to data from Trace, the bond-price reporting system of the Financial Industry Regulatory Authority.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, fell 0.14 basis point to 15.91 basis points. The gauge narrows when investors favor assets such as company debentures and widens when they seek the perceived safety of government securities.

Limited Losses

Funds that purchase loans have seen deposits of $28.5 billion, a 38 percent increase in total assets since the start of the year, according to a report from Bank of America Corp. dated June 6.

Losses on second-lien loans have been limited as returns on junk bonds plummeted following Bernanke’s May 22 testimony to the Joint Economic Committee of Congress in Washington. The Fed could slow the pace of its $85 billion of bond purchases in its “next few meetings,” Bernanke said in the testimony.

Since Bernanke’s comments, junk bonds have lost 2.8 percent to trim gains this year through June 11 to 2.8 percent, according to the Bloomberg USD High Yield Corporate Bond Index. Second-lien loans gave up 0.3 percent in the same period, Barclays data show.

“This is a way of getting outperformance on the index if default rates are low,” Bell said. “If people were worried about the world, second-liens would have a tougher time.”

‘Best Terms’

The junior loan borrowings fit in between first-lien loans and bonds in a company’s capital structure. Issuers may have restrictions in their credit agreements limiting senior ranking debt and in such cases a second-lien loan may be an option, according to David Breazzano, president of DDJ Capital Management LLC, which manages more than $6 billion in below investment-grade assets.

“Companies want to take advantage of where they can get the best terms for financing,” he said in a telephone interview from Waltham, Massachusetts. “There are cases where a company looks to split its offerings into multiple tranches to get a better rate on the overall deal.”

First-lien investors may demand an interest premium to lend to a borrower whose leverage, or the ratio of debt to earnings before interest, taxes, depreciation and amortization is too high, according to Breazzano. An issuer can work around that by reducing the size of the senior loan and pay a higher rate on a smaller second-lien piece, which may end up offering a better overall rate, he said.

Atkins Loan

Atkins Nutritionals borrowed $355 million in the form of a $100 million second-lien loan that paid interest at 8.5 percent more than Libor with a 1.25 percent minimum on the lending benchmark and a $255 million senior loan that paid 5 percent more than benchmark with a similar floor, Bloomberg data show.

Rite Aid lowered the rate on a $500 million second-lien loan it’s seeking to tender for second-lien notes, according to a person with knowledge of the transaction.

The debt, due in eight years, will pay interest at 3.88 percentage points more than the Libor, down from 4.25 percentage points initially proposed, said the person, who asked not to be identified because terms are private. The lending benchmark will have a 1 percent minimum.

The company chose loans over issuing new bonds as “the term loan has a more favorable call structure, which gives us maximum flexibility in our capital structure,” Susan Henderson, a spokeswoman for Camp Hill, Pennsylvania-based Rite Aid said in an e-mail.

Stephanie Walter, a spokeswoman for Denver-based Atkins Nutritional declined to comment on the company’s financing.

The less liquid securities usually sold in smaller portions than junk bonds are benefiting from low default rate expectations and as investors turn to debt that stands to gain during a period of rising interest rates.

“The demand side of the market remains very strong,” Invesco’s Baskind said. “More issuance of second-lien debt is a natural evolution of the supply-demand imbalance.”

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