What is a Leveraged Loan?

For companies that are growing quickly, a leveraged loan can be an essential tool for financing their expansion. But, one downside of leveraged loans is that they often have higher interest rates than traditional loans. If the company isn’t able to make the payments, it could default on the loan and get into serious financial trouble.

If you’re unfamiliar with the leveraged loan market but would like to learn more, read on as we dive deep into what a leveraged loan is and how it works.

What is a leveraged loan and how does it work?

In a nutshell, a leveraged loan is a type of syndicated loan that is typically extended to below investment grade companies that have high levels of debt. While financial institutions used to primarily keep track of their loans through a ledger, some institutions now form syndicates to jointly loan funds to a borrower. In addition to this lending, syndicates also sell loans to investors, including mutual funds, exchange-traded funds, insurance companies, and pension funds.

Though there isn’t a strict or universal definition for what constitutes a leveraged loan, in terms of default rate, lenders usually consider leveraged loans to have an above-average risk. In general, leveraged loans are secured by collateral, such as the borrower’s real estate property, or even intellectual property like trademarks and other confidential information. Moreover, they’re typically structured as floating-rate loans, which means that the interest rate on the loan will fluctuate based on changes in market rates.

How are leveraged loans used?

Leveraged loans are often used to finance mergers and acquisitions, or to provide working capital for businesses or institutional investors with high levels of debt. In some cases, they may also be used to refinance debt.

Because a leveraged loan is often riskier for lenders, these loans have a higher interest rate than other types of loans. Despite the high borrowing cost, they can be a crucial source of financing for companies that are unable to obtain traditional financing.

Pros and cons of leveraged loans

Every type of financing comes with its pros and cons. Here are some advantages and drawbacks of using leveraged loans for your business.

Examples of leveraged finance products

• Collateralized loan obligations. A collateralized loan obligation (CLO) is a type of structured finance product that collateralizes a pool of loans and repackages them into different tranches that are sold to investors. CLOs are typically managed by an asset manager who is responsible for selecting the loans that go into the pool, as well as managing the pool on an ongoing basis.
• Covenant-lite loans. Covenant-lite loans are a type of corporate loan that have fewer restrictions (or covenants) than traditional loans. Because covenant-lite loans offer more flexibility to borrowers, they have become increasingly popular in recent years. However, they also tend to be more expensive and riskier than traditional loans.
• Mezzanine finance. Mezzanine financing is a type of junior debt that is typically used by businesses to finance the purchase of capital assets or to fund other significant expenditures. The debt sits above equity and is subordinate to senior debt, which means that it ranks below senior debts in terms of priority if the borrower defaults on its obligations.
• High-yield bonds. High-yield bonds are corporate bonds that offer a higher yield than investment-grade bonds. They are also known as junk bonds. These bonds are usually issued by companies with lower credit ratings and are considered to be riskier than investment-grade bonds. While they can be a great way to earn a higher return on investment for investors, these bonds also have a greater chance of default.

If you’re looking for a more straightforward form of financing for your business, you may want to consider the below lenders for a business loan. You can filter your lender search by your credit score as well, so even if you have bad credit, you can find a loan for your financial situation.

FAQs

What is the difference between high-yield and leveraged loans?

High-yield bonds are also known as junk bonds. They are debt instruments that are considered to be high risk because they’re issued to companies with weak credit ratings. As a result, these bonds typically offer higher interest rates than other types of debt instruments.

Leveraged loans are another type of high-risk debt. These loans are made to companies or individuals that already have a significant amount of debt. The interest rate on a leveraged loan is usually floating, meaning that it can change over time. In contrast, the interest rate on a high-yield bond is fixed, meaning that it will remain the same for the life of the bond.

Another major difference between high-yield bonds and leveraged loans is that high-yield bonds are typically unsecured, whereas leveraged loans are secured. Leveraged loans are generally secured with first liens on the collateral. This means that in the event of a default, creditors have a better chance of recouping their investment through the sale of collateral.

Why are leveraged loans attractive?

Though interest rates on leveraged loans can often be quite high, there are a number of selling points that make leveraged loans attractive to borrowers.

For one, leveraged loans can be used to finance a wide variety of activities, including acquisitions, expansions, and refinancing. Also, leveraged loans can be structured as revolving lines of credit, which gives borrowers flexibility in how they use the funds.

Should I get a leveraged loan?

Leveraged loans are typically used by companies such as private equity firms to finance business activities. With that in mind, it’s probably not the best personal finance option. So, if you’re just hoping to get some cash for your home renovation, a leverage loan might not be the best fit for you.

Get the right financing for your business

When you’re ready to take your business to the next level, it’s important to explore all of your financing options. A leveraged loan can be a viable choice for businesses that are expanding quickly but have a high level of debt and credit ratings. However, it also comes with relatively expensive borrowing costs. And if you’re not careful, your company could be in deep water.

Before taking the plunge to take out a loan, research your options, and consider the different types of business loans or even business lines of credit you could qualify for. This way, you can find the perfect financing option for your business needs.