Leveraged Loans: Definition, Features & Who Uses Them

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 ratingCredit RatingA credit rating is an opinion of a particular credit agency regarding the ability and willingness an entity (government, business, or individual) to fulfill its financial obligations in completeness and within the established due dates. A credit rating also signifies the likelihood a debtor will default./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:

1. Is rated BB+ or lower (non-investment grade); or
2. 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)Leveraged Buyout (LBO)A leveraged buyout (LBO) is a transaction where a business is acquired using debt as the main source of consideration.. 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 sheetBalance SheetThe balance sheet is one of the three fundamental financial statements. The financial statements are key to both financial modeling and accounting. 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 equipmentPP&E (Property, Plant and Equipment)PP&E (Property, Plant, and Equipment) is one of the core non-current assets found on the balance sheet. PP&E is impacted by Capex,).

Example

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 ReserveFederal Reserve (The Fed)The Federal Reserve is the central bank of the United States and is the financial authority behind the world’s largest free market economy. 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.

More Resources

To keep learning and advancing your career, the following CFI resources will be helpful:

• Debt CovenantsDebt CovenantsDebt covenants are restrictions that lenders (creditors, debt holders, investors) put on lending agreements to limit the actions of the borrower (debtor).
• Leverage RatiosLeverage RatiosA leverage ratio indicates the level of debt incurred by a business entity against several other accounts in its balance sheet, income statement, or cash flow statement. Excel template
• Structured FinanceStructured FinanceStructured finance deals with financial lending instruments that work to mitigate serious risks related to complex assets. Borrowers with greater needs, such as corporations, seek structured finance to deal with complex and unique financial instruments and arrangements to satisfy substantial financial needs.
• Syndicated LoanSyndicated LoanA syndicated loan is offered by a group of lenders who work together to provide credit to a large borrower. The borrower can be a corporation, an individual project, or a government. Each lender in the syndicate contributes part of the loan amount, and they all share in the lending risk. One of the lenders act as the manager