The leveraged loan market is a dynamic and evolving market that has been rapidly expanding with new investors over the last 15 years. The market is very large and growing, and had total outstanding loans of $625B in August 2013 compared to $73B in 1998, according to S&P/LSTA. The market is projected to hit $1 Trillion in 2014 as demand continues to grow.

 

What is a leveraged Loan:

 

A leveraged loan is a syndicated loan with single set of terms, but multiple lenders (usually 10 or more) each providing a portion of the funds of the loan. The loans are typically senior secured loans which sit at the topmost rank in the borrower’s capital structure, and generally feature more restrictive covenants than traditional loans. These restrictive covenants include regular reviews of various operating performance measures such as leverage and interest coverage to ensure that companies are in compliance. The loans are extended by banks to speculative companies that are rated below investment grade. Interest rates on leveraged loans are mostly floating rates over a benchmark interest rate, usually the three or six month London Interbank Offered Rate (LIBOR). The rates on the loans pay a credit spread over the benchmark rate.  The loans are structured, arranged, syndicated and administered by one or several commercial or investment banks known as "arrangers."

 

Leveraged loans are usually raised for five main reasons.

 

Refinance of existing debt

Funding of leveraged buyouts

Corporate acquisitions

Working capital needs

Shareholder-friendly activities

 

Primary market for Leveraged loans: 

 

Institutional investors are the biggest purchasers of leveraged loans, and were purchasing over 70% of all syndicated loans until late 2008 when the market contracted. The biggest institutional investors of leveraged loans are Collateral Loan Obligations (CLO's), Hedge and Prime rate funds, distressed and high yield funds, insurance companies and banks. The increasing role of institutional investors in the loan market is attributed to banks selling off loan assets in order to free up capital and clear off their balance sheets due to the high capital cost of these holding loans.

 

The composition of high yield bond and loan financing as a percentage of capitalization for most companies has evolved over the years, with loans making up a larger proportion of the capital structure of most companies. A  typical leveraged structure of a speculative company is capitalized with between 50-55 percent loans, 30-35 percent bonds, and 20-25 percent equity.

 

 

 

The Syndication Process:

Syndicated loans are mostly underwritten on a best-effort-basis, and have market flex language or reverse  market flex language. A best-effort-basis means the arrangers take up the loan onto their books and guarantee that the full loan will be subscribed . Under this process if the loan fails to be fully subscribed, the size or pricing on the loan could be adjusted.

 

• Market flex language allows borrowers to offer arrangers the flexiblity to adjust loan terms and pricing  by increasing a loan spread above it reference benchmark to ensure that the loan is fully subscribed.

• Reverse market flex language allows arrangers to tighten loan spreads in response to prevailing market conditions or oversubscriptions 

 

Loan structure: 

Leveraged loans have a revolving line of credit and one or more term loans attached to them; e.g term loan A, B,C etc. The loans are classified as either pro rata or institutional loans.

 

• Pro rata loans are distributed to banks and usually comprise of a revolving line of credit and term loans with maturities of three to five years. These loans have a great amount of amortization before maturity.

 

• Institutional loans are distributed to nonbank institutional investors and usually include term loans that mature in five to seven years. The loans have a 1% pay down per year before a balloon payment at maturity

 

 

Loan Recovery and default rates: 

Defaulted loans have historically recovered on average 82% of their par value compared to 37% (on average) for bonds, according to data from Moody's. This is primarily due to the seniority of security on these loans. Their default rates have historically been much lower when compared to high yield bonds.

 

Benefits of Investing in leveraged loans:

 

• Diversification:

 

• Protection against rising interest rates: leveraged loans are less sensitive to interest rate changes due to their shorter durations which is the length of time it takes for the loans to be paid back, and their floating interest rates which reset whenever there is a change in interest rates.

 

• Protection in case of defaut: Loans are able to recover a majority of their par value in case of default due to their seniority in security

 

• Attractive risk-adjusted returns: Loans have a low correlation to other fixed income products but comparable returns to high yield bonds