A leveraged loan is a loan that is extended to businesses that (1) already hold short or long-term debt on their books or (2) with a poor credit rating/history. Leveraged loans are significantly riskier than traditional loans, and, as such, lenders typically demand a higher interest rate to reflect the greater risk.
Criteria for Classification
There are no universal criteria for a leveraged loan. However, S&P Global defines them 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.
The criteria are uncertain in that a loan that is rated BB+ with a spread of LIBOR +110 would be considered a leveraged loan, while a non-rated bond with a spread of LIBOR +110 would not be considered a leveraged loan. Therefore, significant judgment is needed when determining whether to classify a loan as leveraged.
Usage for Leveraged Loans
As outlined by S&P Global, issuers use proceeds from leveraged loans for four main purposes:
1. To support mergers and acquisitions (M&A) deals
Leveraged loans are commonly used to support a specific type of M&A deal – a leveraged buyout (LBO). In an LBO, a portion of the funds consists of leveraged loans.
2. Recapitalize a company’s balance sheet
Leveraged loans can be used to change a company’s balance sheet when repurchasing a portion of the company’s stock.
3. Refinance debt
This type of loan can also be used to refinance the existing debt of the company.
4. General corporate purposes
Such loans may be used to support the company’s daily day-to-day operations or in providing asset financing (for example, purchase of new property, plant, and equipment).
A company is looking to use a leveraged loan to support the acquisition of a new long-term asset. The company will issue $1,000,000 in bonds at an interest rate of LIBOR +50. If the loan is rated non-investment grade, is the loan considered leveraged or not?
Using the criteria set by S&P Global, the loan above would be considered a leveraged loan because the loan is non-investment grade (non-investment grade rating is BB+ or lower).
Loans in the Marketplace
As leveraged loans provide an interest rate based on LIBOR +rate, a higher interest rate provides a greater return for investors. With the Federal Reserve having raised interest rates numerous times from 2005-2018, the demand for leveraged loans increased substantially. However, 2019 has shown a reversal in the amount of demand.
As reported by the Financial Times, investors pulled over $300 million from mutual and exchange-traded funds that invested in U.S. leveraged loans in the week ending July 10, 2019. As expectations for interest rate cuts by the Federal Reserve sets in, demand for such loans is expected to decline accordingly.
When interest rates increase, the return on a leveraged loan increases and drives demand from investors. On the contrary, when interest rates decline, the return decreases, and demand from investors diminishes.
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