What Is a Leveraged Loan?
A leveraged loan is a type of loan provided to companies or individuals with existing high levels of debt or a poor credit history. Lenders view leveraged loans as carrying a heightened risk of default, making them more expensive for borrowers.
Businesses or individuals with debt often face higher interest rates with leveraged loans compared to conventional loans. These rates reflect the increased risk associated with lending to such entities.
**Key Takeaways**
- A leveraged loan is extended to entities with significant debt or poor credit history.
- Lenders perceive leveraged loans as posing a higher risk of default, resulting in increased costs for borrowers.
- Leveraged loans typically incur higher interest rates than standard loans due to the elevated risk factor.
Understanding Leveraged Loans
Leveraged loans are tailored, organized, and managed by at least one commercial or investment bank, known as arrangers, who may later distribute the loan to other financial institutions through a process called syndication to mitigate risk.
The definition of a leveraged loan varies among market players. Some use a spread-based criterion, employing a floating rate tied to benchmarks like SOFR. Alternatively, a borrower’s credit rating, typically below investment grade, may define a leveraged loan.
During syndication, banks can modify terms, including price flexibility. This adjustment can involve raising the ARM margin if demand is low, known as upward flex, or lowering the spread over SOFR if demand is high, known as reverse flex.
How Do Businesses Use Leveraged Loans?
Businesses commonly employ leveraged loans for M&A activities, balance sheet restructuring, debt refinancing, or general corporate purposes.
For instance, M&A transactions often involve leveraged buyouts using borrowed funds. Balance sheet recapitalization may include issuing debt to repurchase stock or pay dividends to shareholders.
**Note**
Leveraged loans allow entities with high debt or poor credit history to access cash, albeit at higher interest rates.
Example of a Leveraged Loan
S&P’s Leveraged Commentary & Data (LCD) categorizes loans as leveraged if rated BB- or lower.
Alternatively, nonrated or BBB- or higher loans can be considered leveraged if secured by a first or second lien.
What Is the Difference Between a Bank Loan and a Leveraged Loan?
Leveraged loans, also referred to as floating-rate loans, are initially provided by financial institutions and then sold to investors. Companies utilize these funds for debt refinancing, M&A, or project financing, often targeting entities with credit ratings below investment grade. Collateral such as real estate, equipment, or intellectual property secures these loans.
How Do Funds Invest in Leveraged Loans?
Investment funds, including mutual funds and ETFs, may include leveraged loans in their portfolios based on their investment strategy. Portfolio managers may allocate varying levels of funds to these loans, taking advantage of their higher interest rates to potentially yield increased returns for investors.
The Bottom Line
Leveraged loans cater to entities with substantial debt or poor credit history, subject to higher interest rates owing to the associated risk. Definitions of leveraged loans can vary, often centered around spreads and benchmarks like SOFR.
The terms of leveraged loans allow banks flexibility during syndication, adjusting aspects like the ARM margin. These loans are crucial for companies engaged in M&A, balance sheet restructuring, and other business operations.