What is a Leveraged Loan: Overview & Examples

Key Takeaways

• Depending on their investment strategy, some mutual funds, exchange-traded funds, and other investment funds may hold leveraged loans in their portfolios. 

• A collateralized loan obligation, or CLO, is a portfolio of mostly leveraged loans that is managed and securitized as a fund.

• Companies that receive leveraged loans usually have credit ratings that are under investment grade, with the loans secured by collateral such as property and equipment. 

Despite inherent risks, it is not uncommon for leveraged loans to offer better returns than other fixed-income assets, as they do currently.

But what is a leveraged loan? Here is an overview, with examples, and how to invest in such loans.

What is a Leveraged Loan?

While there is no set definition, these generally are loans to individuals or companies that already have a significant amount of debt or low credit rating.  

Because of the risk of borrower default, lenders generally charge higher interest rates for leveraged loans. 

Understanding Leveraged Loans

These loans go to individuals or companies that have long- or short-term debt or a poor credit rating.

For example, if a loan is rated BB- or less, S&P’s Leveraged Commentary & Data puts it in its leveraged loan category. Also, if a loan is secured by a first or second lien, it also can be classified as a leveraged loan

What are the Types of Leveraged Loans?

There are three primary types of leveraged loans, to wit:

• Underwritten deal. Here, the arranger uses the deal, mostly in Europe, for leveraged loan syndication. Due to associated risks, underwriting is usually lucrative, fee-wise. Loan underwriting can also make the financial institution be seen as more competitive, which can be beneficial in terms of future mandates.
• Best-efforts syndication. With this type of loan syndication, which is more prevalent in the U.S., the arranger is not required to underwrite the whole loan amount. If the loan amount is undersubscribed, it is possible the credit will not close and may need market adjustments. If undersubscription continues, the borrower may have to accept the lower loan total.
• Club deal. With this transaction type, the lender – typically private equity – makes the loan for an M&A function.  The size of the loan is usually bigger than what could be funded by anyone’s lenders independently. It permits investors to gain targets formally exclusively available to bigger strategic players.

What are the Classifications for a Leveraged Loan?

For its part, S&P Global does define a leveraged loan as one that is rated BB+ or lower (non-investment grade) or does not have that rating but has a spread of LIBOR + 125 and is secured by a lien.

Because the criteria remains somewhat uncertain, care is needed when classifying a loan as leveraged.

How Does Leveraged Loan Differ from Bank Loan?

Unlike traditional bank loans, which generally require good credit and debt-to-income ratios, leveraged loans are extended to markedly indebted people or companies or those with lesser credit histories.    

Leveraged loans are also substantially riskier than traditional loans, and so generally have higher interest rates than bank loans.

Companies that receive leveraged loans usually have credit ratings that are under investment grade and the loans are secured by collateral such as property and equipment. 

What are Leveraged Loans Used For?

As a type of corporate finance, leveraged lending is commonly used for mergers and acquisitions, refinancing, business recapitulation, equity buyouts, product-line expansions, and to refinance debt. 

What are the Risks Associated with Investing in Leveraged Loans?

Because of the higher risk of default in the eyes of lenders, leveraged loans are more costly to the borrower. That means that interest rates tend to be higher than for traditional bank loans.

What are the Potential Benefits of Investing in Leveraged Loans?

While such loans are risky and generally carry higher rates, there are advantages to leveraged loans, including:

• Access to capital that can be used for some advancement that likely would not be possible sans leverage. If executed carefully, such financial leverage can multiply each dollar.
• While commonly used for acquisitions and buyouts, leveraged loans work particularly well for short-term business needs due to higher borrowing costs and the risk of too much debt.

How Can You Invest in Leveraged Loans?

Depending on their investment strategy, some mutual funds, exchange-traded funds, and other investment funds may hold leveraged loans in their portfolios. There are some funds that, as part of their diverse portfolio, make a modest investment in leveraged loans.

Leverage loans also play a prominent role in collateralized loan obligations, known as CLOs. 

How are Leveraged Loans Used in CLOs?

A collateralized loan obligation, or CLO, is a portfolio of mostly leveraged loans that is managed and securitized as a fund. Such assets are usually senior secured loans, which, in the event of an insolvency, have the advantage of priority of payment over other claimants.  

How to Invest in CLOs?

Collateralized loan obligations (CLOs), which feature potentially attractive returns with limited risk, are among highly vetted investment opportunities offered by Yieldstreet, the leading platform for alternative investments. 

As the more than 100 underlying loans make interest payments, investors in Yieldstreet CLOs receive quarterly income. So far this year, net annualized returns total 11.3%, compared to 3.7% for investment-grade bonds and 7.3% for high-yield bonds.  

Because they access diversified funds, Yieldstreet’s CLOs also serve another essential purpose, and that is portfolio diversification. Spreading investments among as well as within varying asset classes helps to manage risk and could even improve returns. In fact, a diversified portfolio is foundational to long-term investment success. 

Alternative investments can be a good way to help accomplish this. Traditional portfolio asset allocation envisages a 60% public stock and 40% fixed income allocation. However, a more balanced 60/20/20 or 50/30/20 split, incorporating alternative assets, may make a portfolio less sensitive to public market short-term swings. 

Real estate, private equity, venture capital, digital assets, precious metals and collectibles are among the asset classes deemed “alternative investments.” Broadly speaking, such investments tend to be less connected to public equity, and thus offer potential for diversification. Of course, like traditional investments, it is important to remember that alternatives also entail a degree of risk. 

In some cases, this risk can be greater than that of traditional investments.

This is why these asset classes were traditionally accessible only to an exclusive base of wealthy individuals and institutional investors buying in at very high minimums — often between $500,000 and $1 million.  These people were considered to be more capable of weathering losses of that magnitude, should the investments underperform.

However, Yieldstreet has opened a number of carefully curated alternative investment strategies to all investors. While the risk is still there, the company offers help in capitalizing on areas such as real estate, legal finance, art finance and structured notes — as well as a wide range of other unique alternative investments. 

Moreover, investors can get started with a relatively small amount of capital. Yieldstreet has opportunities across a broad range of asset classes, offering a variety of yields and durations, with minimum investments as low as $10,000.

Learn more about the ways Yieldstreet can help diversify and grow portfolios.

In Summary

Before buying shares from a fund that invests in leveraged loans, investors should review all the fund’s available information, including its latest shareholder report and prospectus. They should also fully understand the risks and benefits, including fees. Investing in CLOs can be a smart way to enter the leveraged loan market and can also help with portfolio diversification.