What is the Leveraged Loan Market? Leveraged Lending Explained

A leverage loan is a financial tool in the form of a loan available to companies or individuals with a considerable amount of debt or a low credit rating. Many lenders consider leveraged loans to be at increased risk of default, and so charge more in the form of higher interest rates to borrowers. These higher interest rates reflect the increased default risk being carried by the issuing financial institution.

Criteria for Leverage Loans

There is no one criteria for a leveraged loan. The S&P Global defines a leveraged loan as a loan that is rated BB+ or lower (non-investment grade); or is not rated BB+ or lower but has a spread of LIBOR +125 and is secured by a first or second lien.

A loan is considered a leveraged loan if it is rated BB- or lower. A loan that is nonrated of BBB- or higher is also classified as a leveraged loan is secured by a first or second lien.

The criteria are uncertain in what is considered a common example of a leveraged loan based on London interbank offered rate (LIBOR) spread. Therefore, careful consideration of credit risk is needed when determining whether to classify a loan as leveraged.

Understanding Leveraged Loans

Leveraged loans are administered, structured and arranged by at least one financial institution, usually a commercial or investment bank. They are called the arrangers of the loan and may put it up for sale (known as syndication) to other banks or investors to lower the risk for the lenders.

Many of the loans pay a floating rate based on the Secured Overnight Financing Rate (SOFR) or another benchmark, plus a stated basis, called an ARM margin. If the ARM margin is above a certain level, the loan is considered a leveraged loan. Some base the loan classification on the borrower's credit, usually rated below investment grade.

Banks have the option to change the terms during syndication of the loan, known as a price flex. If demand for the loan is too low at the original interest level, the ARM can be raised in what is called an upward flex. On the flip side, if demand for the loan is high, the spread over the SOFR can be lowered in a reverse flex.

What Is the Difference Between Bank Loans and Leveraged Loans?

Leveraged loans, also marketed as floating rate loans or bank-backed loans, in which a bank loan is issued by a bank or other financial institutions and then sold to investors. A company may use that money for refinancing debts, merger and acquisitions funding, or financial investments.

Companies receiving these leveraged loans provide to usually have a less the optimal balance sheet, poor credit ratings or don't have investments, meaning their credit rating is below investment grade.

These leveraged loans typically are secured by collateral such as borrowers' property and equipment, or intellectual property such as brand trademarks, customer lists and clients' lists.

How Do Businesses Use Leveraged Loans?

Mergers and acquisitions (M&A) often take place in the form of a leveraged buyout (LBO). An LBO occurs when one company or private equity group buys a public entity and privatizes it. Debt is used in the refinancing of the purchase price of the entity. Another use for leveraged loans is recapitalization.

This is a procedure to refinance debt or alter an asset’s capital structure, through the use of the capital markets. Commonly, debt is issued to buy back stock or offered as a dividend, or payment, to shareholders.

How Do Funds Invest in Leveraged Loans?

A fund can hold a leveraged loan in their investment portfolio depending upon its investment strategy. In many cases some funds can make small investments in leveraged loans and credit in a diverse portfolio, while mutual funds, exchange traded funds and other institutional investors can make large investments in them.

Fund managers can buy these loans at higher-than-average interest rates in hopes of boosting fund returns.

What Issues Face the Leveraged Loan Market?

In the vast financial arena, the leveraged loan market is the key mechanism enabling infusion of funds for businesses looking to finance projects increase their growth or expand their operations. All stakeholders and market participants must understand the complexity of this industry and asset class.

Letters of Credit (LOC)

The LOC is an assurance by lenders that banks will pay the borrowers' debt when the borrower doesn't.

How are Leveraged Loans Priced? 

Most loans are floating rates which means loans have interest rates that periodically return money back on an annual spread on an average basis rate, the SOFR. In the majority of the situations, borrowers are locked into a fixed rate for 1 year. Syndicated loan pricing options include Prime, SOFR, CD and other fixed-rate alternatives. SOFR emerged as a replacement to LIBOR which was historically the base rate on leveraged loans.

StoneX: Connecting clients to markets for 100 years

As the financial landscape changes, the lessons from leverage lending markets demonstrate that it is essential for the borrower to navigate complex financings and borrowings. Let a StoneX advisor help guide you through the complexities of leveraged loans to a new world of financial possibilities.