Leveraged loan is a commercial loan provided to individuals or companies with a poor credit history or huge amounts of debt. Since the lenders are aware of borrowers’ poor credit history, they assume that borrowers are very likely to default on loans, thus they charge more on the loans and raise the interest rate.
Currently, we can use interest spread or investment grade to define leveraged loan. Under most circumstances, loans have a floating rate which used LIBOR (London Inter-bank Offered Rate) as benchmark and a spread (an extra interest margin). If a loan’s interest margin has been raised above a certain level, it can be considered as a leveraged loan. Besides, some people use investment grade to distinguish leveraged loans. If the investment grade is lower than investment grade, it is seen as a leveraged loan.
How does leveraged loan work?
Leveraged loans are structured and issued by more than one financial institution which are called arrangers. The institutions are usually commercial or investment bank and they may sell the loans to other banks or investors subsequently in order to lower the risk.
Arrangers are able to change the terms, which gives leveraged loans price flexibility. The so-called price flexibility is reflected in the change of interest margin. If the demand for the loan is higher than the one at original interest level, the interest margin will increase; if the demand is lower than the one at original interest level, the interest margin will decrease.
Leveraged loans have practical uses and the most important one is to finance M&A (Mergers and acquisitions). M&A refers to the process that a company take a public entity private by purchasing its stocks. When that occurs, M&A will take place in the form of LBO (leveraged buyout) and that is to buy the stocks with leveraged loans.
Pros and cons of leveraged loans
- Leveraged loans can help borrowers gain capital. For those who have a poor credit history, leveraged loans give them an opportunity to borrow money easily.
- Leveraged loans can finance companies for acquisitions and buyouts.
- Leveraged loans have a high level of industry diversification.
- Leveraged loans have greater transparency.
- Leveraged loans have higher interest rate and cost more.
- Leveraged loans’ sale can take 17 days to two months to settle, which causes difficulties to evaluate the loan portfolios.
- Leveraged loans have no call protection.
- Leveraged loans have very short durations, giving them great volatility and low returns.