What is a Leveraged Loan?
A leveraged loan is a loan that is extended to businesses that (1) already have short or long-term debt on its books or (2) have 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 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.
The criteria for a leveraged loan are indefinite 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 a “leveraged loan” or not.
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 kind 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 by issuing leveraged loans to repurchase a portion of the company’s stock.
3. Refinance debt
Leveraged loans can be used to refinance the existing debt of the company.
4. General corporate purposes
Leveraged loans can be used to support the company’s daily day-to-day operations in addition to providing asset financing (for example, new property, plant, and equipment).
Example of a Leveraged Loan
A company is looking to issue a leveraged loan to support the acquisition of a new long-term asset. The company will issue $1,000,000 in loans at an interest rate of LIBOR +50. If the loan is rated non-investment grade, is the loan considered a leveraged loan?
Using the criteria for a leveraged loan by S&P Global, the loan above would be considered a leveraged loan due to the fact that the loan is non-investment grade (non-investment grade rating is BB+ or lower).
Leveraged 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, demand for leveraged loans has increased substantially. However, 2019 has shown a reversal in demand for leveraged loans.
As reported by the Financial Times, investors pulled over $300 million from mutual and exchange-traded funds that invested in US leveraged loans in the week ending July 10, 2019. As expectations for interest rate cuts by the Federal Reserve set in, demand for leveraged loans is expected to decline accordingly.
As such, 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 on a leveraged loan decreases, and demand from investors diminish.
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