Leveraged Loan

What Is a Leveraged Loan?

A leveraged loan is a type of loan that is extended to companies or people that as of now have significant measures of debt or poor credit history. Lenders consider leveraged loans to carry a higher risk of default, and subsequently, a leveraged loan is more expensive to the borrower. Default happens when a borrower can't make any payments for an extended period. Leveraged loans for companies or people with debt will quite often have higher interest rates than normal loans. These rates mirror the higher level of risk implied in giving the loans.

There are no set rules or criteria for characterizing a leveraged loan. Some market participants base it on a spread. For example, a large number of the loans pay a floating rate, normally based on the London Interbank Offered Rate (LIBOR) plus a stated basis or ARM margin. LIBOR is viewed as a benchmark rate and is an average of rates that global banks loan to one another.

On the off chance that the ARM margin is over a certain level, it is viewed as a leveraged loan. Others base the classification on the borrower's credit rating, with loans rated below investment grade, which is sorted as Ba3, BB-, or lower from the rating agencies Moody's and S&P.

Grasping Leveraged Loans

A leveraged loan is structured, organized, and administered by something like one commercial or investment bank. These institutions are called arrangers and hence may sell the loan, in a cycle known as syndication, to different banks or investors to bring down the risk to lending institutions.

Regularly, banks are permitted to change the terms while partnering the loan, which is called price flex. The ARM margin can be raised in the event that demand for the loan is lacking at the original interest level in what is alluded to as up flex. On the other hand, the spread over LIBOR can be brought down, which is called reverse flex, assuming demand for the loan is high.

As per a declaration by the Federal Reserve, banks ought to stop composing contracts utilizing LIBOR toward the finish of 2021. The Intercontinental Exchange, the authority responsible for LIBOR, will stop distributing one-week and two-month LIBOR after Dec. 31, 2021. All contracts utilizing LIBOR must be wrapped up by June 30, 2023.

How Do Businesses Use Leveraged Loans?

Companies normally utilize a leveraged loan to finance mergers and acquisitions (M&A), recapitalize the balance sheet, refinance debt, or for general corporate purposes. M&A could appear as a leveraged buyout (LBO). A LBO happens when a company or private equity company purchases a public entity and takes it private. Normally, debt is utilized to finance a portion of the purchase price. A recapitalization of the balance sheet happens when a company utilizes the capital markets to change the creation of its capital structure. A standard transaction issues debt to buy back stock or pay a dividend, which are cash rewards paid to shareholders.

Leveraged loans permit companies or people that as of now have high debt or poor credit history to borrow cash, however at higher interest rates than expected.

Illustration of a Leveraged Loan

S&P's Leveraged Commentary and Data (LCD), which is a provider of leveraged loan news and analytics, places a loan in its leveraged loan universe on the off chance that the loan is rated BB-or lower. On the other hand, a loan that is nonrated or BBB-or higher is in many cases classified as a leveraged loan on the off chance that the spread is LIBOR plus 125 basis points or higher and is secured by a first or second lien.

Correction — March 8, 2022: A previous variant of this article erroneously utilized the term "net interest margin" rather than "ARM margin."

Highlights

• Leveraged loans have higher interest rates than run of the mill loans, which mirror the increased risk implied in giving the loans.
• Lenders consider leveraged loans to carry a higher risk of default, and subsequently, are more expensive to the borrowers.
• A leveraged loan is a type of loan extended to companies or people that as of now have significant measures of debt or poor credit history.