Leveraged loans are what you would call a tautology. They are exactly what the name suggests, loans that are simply arranged by banks for companies that already owe a lot. Most of these loans are issued in American and then are packaged into “collateralized loan obligations.”
These loans are then sliced up by private-equity firms and apportioned to their investors in order to fulfill their thirst for risk.
According to a data provider, S&P Global Market Intelligence, over a third of leveraged loans end up refinancing existing debt. A good chunk of these loans is even used to finance mergers and buyouts whereas some end up paying private-equity firms’ dividends.
But what exactly is a leveraged loan?
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What is a Leveraged Loan?
Leveraged loans are also considered by lenders to carry a higher risk of default. This is why leveraged loans are usually more costly for the borrower.
Defaulting on a leverage loan means being unable to make any payments for an extended period of time. For companies or individuals that have debt, the interest rates for a leveraged loan tend to be higher than typical loans. These rates can reflect the level of risk that the lender takes on when issuing the loan. Consequently, the leveraged loan default rates are also high.
The leveraged loan definition is not set by rules or criteria. Some market participants tend to base it on a spread. For instance, many of the loans have to pay a floating rate that is typically based on the London Inter-bank Offered Rate (LIBOR) including a stated interest margin. The LIBOR is used as a benchmark rate and is considered to be an average rate at which global banks lend to each other.
A leveraged loan is any loan whose interest margin is above a certain level. Whereas others use rating to decide which loan is a leveraged loan. Loans rates below investment grade are categorized as Ba3, BB-, or lower from the rating agencies Moody’s and S&P.
How a Leveraged Loan Works?
A leveraged loan is either structured, administered or arranged by an investment bank or a commercial one. These institutions are known as arrangers and may subsequently sell the loan to other banks or investors through a process called syndication in order to lower the risk to lending institutions.
Banks are typically allowed to change the terms when the loan is syndicated. This is known as price flex. If the demand for the loan at the original interest level is insufficient, the interest margin can be raised which is called upward flex. Conversely, if demand for the loan is high, the spread over LIBOR can be lowered which is referred to as reverse flex.
How is a Leveraged Loan Used?
Companies usually use a leveraged loan to finance their mergers and acquisitions (M&A), refinance debt, recapitalize the balance sheet or use it for general corporate purposes. Mergers and acquisitions (M&A) could also take the form of a leveraged buyout (LBO).
An LBO is when a company or private equity company purchases a public entity and makes it private. This debt is typically used to finance a portion of the purchase price. A recapitalization of the balance sheet will occur when a company uses the capital markets in order to change the composition of its capital structure. A typical transaction would issue debt to buy back stock or pay a dividend. These dividends are cash rewards that are paid to shareholders.
As leverage loans have an interest rate based on LIBOR +rate, a higher interest rate will provide a greater return for investors. With the Federal Reserve having raised interest rates numerous times from 2005-2018, demand for leveraged loans have increased substantially. However, 2019 has brought a reversal in the amount of demand.
As reported by the Financial Times, investors had pulled over $300 million from exchange-traded and mutual funds that were invested in US leveraged loans in the week ending July 10, 2019. The demand for such loans is expected to drop accordingly as expectations for interest rate cuts set in by the Federal Reserve.
When the interest rates increase, the return on a leveraged loan will increase and will drive demand from investors. On the contrary, when the interest rates drop, the return will decrease and demand from investors will also diminish.
Example of a Leveraged Loan
S&P’s Leveraged Commentary & Data (LCD) is a provider of leveraged loan news and analytics. It will place the loan in its leveraged loan universe if the loan has been rated BB- or lower.
Alternatively, if a loan is nonrated or BBB- or higher, it is often classified as a leveraged loan if the spread is LIBOR plus 125 basis points or higher. It must also be secured by a first or second lien.
So what is a leveraged loan?
A leveraged loan is essentially a commercial loan provided by a group of lenders. Commercial or investment banks known as arrangers take part in the structuring, arranging and administering of the loan.
It is usually for businesses that already have a debt on their books, either a short-term one or a long-term debt. Leveraged loans are also a good idea for businesses that already have a poor credit score or a poor credit history. So if you own a business that does not have a good credit score or already have short-term and long-term debts, you can use a leveraged loan to either refinance your debt, support in mergers and acquisitions deals, recapitalize your company’s balance sheet or use it for general corporate purposes.