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What is a leveraged loan?
A leveraged loan is a type of loan that is given to businesses or individuals who already have significant debt or bad credit history. Lenders consider that leveraged loans carry a higher risk of fault, and therefore, a leveraged loan is more expensive for the borrower. Default occurs when a borrower cannot make any payment for an extended period of time. Leverage loans for businesses or indebted individuals tend to have higher interest rates than conventional loans. These rates reflect the higher level of risk associated with issuing the loans.
There are no set rules or criteria for defining a leveraged loan. Some market participants base it on a spread. For example, many loans have a variable rate, usually based on the London Interbank Offered Rate (LIBOR) plus a declared interest margin. LIBOR is considered a benchmark rate and is an average of the rates that global banks lend to each other.
If the interest margin is above a certain level, it is considered a leveraged loan. Others base it on rating, with loans rated below investment grade, which are rated as Ba3, BB- or below by rating agencies. Moody’s and S&P.
Key points to remember
- A leveraged loan is a type of loan given to businesses or individuals who already have significant debt or a poor credit history.
- Lenders consider leveraged loans to carry a higher risk of default and, therefore, to be more expensive for borrowers.
- Leverage loans have higher interest rates than typical loans, which reflects the increased risk involved in issuing the loans.
Understanding a leveraged loan
A leveraged loan is structured, organized and administered by at least one commercial or investment bank. These institutions are called arrangers and can then sell the loan, in a process called syndication, to other banks or investors in order to reduce the risk for credit institutions.
Banks are expected to stop writing contracts using LIBOR by the end of 2021, according to a Federal Reserve announcement. The Intercontinental Exchange, the authority responsible for LIBOR, will stop publishing LIBOR at one week and two. months after December 31, 2021. All contracts using LIBOR LIBOR must be closed by June 30, 2023.
Typically, banks are allowed to change the terms when syndicating the loan, which is called price flexibility. The interest margin can be increased if loan demand falls short of the original interest level in what is called upward flexibility. Conversely, the spread over LIBOR can be lowered, known as reverse flex, if loan demand is high.
How do businesses use a leveraged loan?
Businesses typically use a leveraged loan to finance Mergers and Acquisitions (M&A), recapitalize the balance sheet, refinance debt or for general business purposes. Mergers and acquisitions could take the form of a leveraged buyout (LBO). An LBO occurs when a firm or private equity firm buys a public entity and takes it privately. Typically, debt is used to finance part of the purchase price. A balance sheet recapitalization occurs when a company uses capital markets to change the makeup of its capital structure. A typical transaction issues a debt to buy back shares or pay a dividend, which are cash rewards paid to shareholders.
Leverage loans allow businesses or individuals who already have high debt or a bad credit history to borrow money, but at higher interest rates than usual.
Example of a leveraged loan
S & P’s Leveraged Commentary & Data (LCD), which is a provider of information and analysis on leveraged loans, places a loan in its leveraged loan universe if it is rated BB- or less. Alternatively, a loan that is not rated or BBB- or higher is often classified as a leveraged loan if the spread is LIBOR plus 125 basis points or more and is secured by a first or second lien.
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