A second lien isn't necessarily second in line for payback anymore, as a debt issue last year by a specialty chemicals firm shows.

In May 2012 Momentive Performance Materials issued $250 million in 10.0% senior secured notes in a high-yield offer to repay existing term loans and back a tender offer to pay for a portion of 12.5% second-lien notes due in 2014.

The Columbus, Ohio, company (rated B2 by Moody's Investors Service, CCC by Standard & Poor's) joined with a team of nine bookrunners led by JPMorgan Chase (JPM) to piece together the offering under unique terms: the notes were granted a "1.5-lien" intermediate subordinated standing, and given priority over the 12.5% second-lien notes. The new notes were rated CCC by S&P (later downgraded to CC in December 2012).

As a result, the 12.5% notes as well as the company's other aggregated second-lien notes (which total $1.34 billion, and are also rated CC per S&P) are now subject to a tertiary position - despite their classification as second-lien, said Sharon Bonelli, a managing director with Fitch Ratings.

"They actually made the 1.5 lien the second lien in every aspect but its name," Bonelli said.

The Momentive issue is an example of the increasing complexity of second-lien debt, in which the leverage, priority and even the nomenclature is becoming relative to an issuer's total debt structure, according to a new analysis of the second-lien debt market by Fitch. The topic is important for banks, which often make the underlying loans, handle the debt issuances or buy debt as investors.

Fitch found in a capital structure analysis of 20 U.S. corporate second-lien issuers that the position of second-lien holdings can widely vary based on the median percentage of first-lien holdings, the total leverage of a company and the amount of unsecured debt on hand. In some instances, highly leveraged companies like Beazer Homes, USA (rated Caa1 by Moody's, B- by S&P) and Mohegan Tribal Gaming Authority (Caa1,B-) each had more than 50% of debt in unsecured debt, "which places second-lien debt issues in a relatively advantageous position" in a default scenario, according to Fitch's report.

Conversely, some issuers like Avaya Inc. (B3,B-) include first-lien asset-backed facilities and cash flow-revolvers in addition to first-lien loans and notes that are more senior to second-lien debts.

"On the face of it at first glance, the names might not be reflective of its relative priority within a capital structure," Bonelli said. "There's no consistent market definition of what constitutes a second-lien facility."

In another example, Bonelli pointed out that term loans with priority on property, plant and equipment are sometimes classified as first-lien by lenders, "but others might call it a second-lien facility because it had a second lien on the most liquid assets of the company," she said. "One has to delve into the details and understand the specific collateral package and the specific relative priority in a recovery situation."

The differences in second-lien issuance position were underscored in Fitch's 2012 analysis of 33 U.S. corporate second-lien issuer bankruptcies, where lenders realized a median recovery of 20% and an average recovery of 41%. Breaking down those numbers showed a wide swath of results based on the level of first-lien and unsecured debt held by the second-lien issuers.

Fitch found that 13 of the 33 bankruptcies where companies had only first-lien and second-lien debt outstanding with no unsecured debt, the median recovery of second-lien lenders was only 7%. For eight issuers that had at least 50% of total debt in the lower-priority unsecured debt field, second-lien lenders saw full, 100% recoveries.

The positioning of second-lien loans has not slowed momentum, of course. According to Fitch, the $28.8 billion in year-to-date issue volume in second-lien debt is turning 2013 into the most active year for second-liens since 2007's $40.5 billion in volume. The premiums on second-lien margins over first-liens averaged around 400 basis points for the past four quarters, above the 355 basis points average for the 10-year period prior to September 2013 and above the pre-crisis average level of 338 basis points in 2007.

Fitch also noted that trading of secondary second-lien loans has also "markedly" improved, with narrowing bid differentials with first-lien offerings in the secondary market. Second-lien issues have been trading close to par with an average of 96.9 cents on the dollar year to date through mid-October, compared with 98.8 on first-lien loans.

The demand for second-lien issuance has encouraged companies to trend toward the "covenant-lite" trend, where 46% of second-lien transactions have been issued with relaxed covenant and guarantee provisions. That level is more than triple the levels from 2012, and even dwarfs the percentage in 2007 when covenant-lite second-lien issuance made up 14% of volume totals.

This story originally appeared in LeveragedFinanceNews.com

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