A leveraged loan is a financial product extended to companies or individuals who already grapple with substantial debt or possess a poor credit history. Due to the higher risk of default associated with these borrowers, leveraged loans come with higher costs and elevated interest rates.
Key Insights
- Risk and Borrower Profile: Leveraged loans are typically extended to entities with significant existing debt or lower credit scores.
- Cost to Borrowers: Such loans carry higher interest rates to compensate for the increased risk of default.
- Loan Features: These loans often feature floating interest rates, adjusted periodically to reflect market benchmarks.
Unpacking Leveraged Loans
Leveraged loans are structured, arranged, and managed by one or more commercial or investment banks, known as arrangers. To mitigate risks, these banks may syndicate the loan, selling parts of it to other financial institutions or investors.
The criteria for defining a leveraged loan vary. Many are based on interest rate spreads coupled with a benchmark like the Secured Overnight Financing Rate (SOFR). Adjustments in interest rates (ARM margins) determine if a loan is considered leveraged.
Flexible Rates and Credit Ratings
Leveraged loans are also distinguished by their creditors’ ratings, generally falling below investment grade (ratings like Ba3, BB-, or lower). Banks syndicating the loan may adjust interest rates in response to market demand—a process known as price flex, including upward and reverse flex adjustments.
Purpose of Leveraged Loans in Business
Companies often utilize leveraged loans for various purposes:
- Mergers and Acquisitions: Financing activities like leveraged buyouts (LBO), where companies are taken private.
- Balance Sheet Recapitalization: Modification of capital structure through market operations, often involving debt issuance to repurchase stock or declare dividends.
- Refinancing Debt and General Corporate Use: Businesses may also use these funds to manage existing obligations or fulfill day-to-day operational needs.
Note on Borrowers
Leveraged loans provide financial lifelines to high-debt or low-credit individuals and companies, albeit at higher interest rates that mirror the inherent risks.
Example of a Leveraged Loan
Consider that a loan rated BB- or lower could fall under leveraged territory, as cataloged by providers such as S&P’s Leveraged Commentary & Data (LCD). Even nonrated loans secured by first or second liens might be classified in this category if certain conditions are met.
Leveraged Loans vs. Traditional Bank Loans
While sometimes referred to interchangeably, leveraged loans typically differ from standard bank loans in being floated by banks and secured against collateral like real estate, equipment, or intellectual property. Designed for borrowers with sub-investment grade ratings, these loans offer secured debt positions typically traded among investors.
Investing in Leveraged Loans
Investment funds, including mutual funds and exchange-traded funds (ETFs), may include leveraged loans based on specific strategies. Higher interest rates promise potentially higher returns for these funds, despite their embedded risks.
Conclusion
A leveraged loan is a high-cost borrowing option for entities with extensive debt or poor credit. Their elevated interest rates compensate lenders for the enhanced risk of default. These loans play a crucial, albeit costly, role in refinancing efforts and funding corporate activities like mergers, acquisitions, and balance sheet recalibrations.
Related Terms: floating rate, syndication, investment grade, S&P, Moody’s.
References
- Investor.gov. “Leveraged Loan Funds—Investor Bulletin”.
- The Wall Street Journal. “Companies, Lenders Clash Over Loan Spreads in Switch From Libor”. (Subscription required.)
- Fidelity. “An Opportunity for Income Seekers”.
