# Understanding Leveraged Loans: Risk, Interest Rates, and Examples

![Leveraged Loan: A loan extended to companies or individuals that already have considerable amounts of debt or a poor credit history.](https://www.investopedia.com/thmb/qpXLNg4p2qM8mXNGI_i00-ScuI8=/1500x0/filters:no_upscale():max_bytes(150000):strip_icc()/leveragedloan.asp-FINAL-1-4c77a8c776504d349875d1dadaa6847b.png)

*— Investopedia / Joules Garcia*

> **Definition**
>
> A leveraged loan is a type of loan made for borrowers who already have high levels of debt or a low credit score. These loans are considered high-risk and therefore have higher interest rates.

## What Is a Leveraged Loan?

Leveraged loans are high-risk loans offered to entities with substantial existing debt or poor credit histories. They carry higher interest rates due to the increased risk of default. Typically arranged by banks, these loans may be sold to investors through syndication to distribute risk. Businesses often use leveraged loans for mergers, acquisitions, or to recapitalize their balance sheets.

### Key Takeaways

*   Leveraged loans are extended to borrowers with substantial existing debt or poor credit history and carry higher interest rates due to increased default risk.
*   These loans are often used by businesses to finance mergers and acquisitions, refinance debt, or for general corporate purposes.
*   Leveraged loans are typically sold through a syndication process, where arrangers distribute the loans to other banks or investors in order to manage risk.
*   There are no strict criteria for defining a leveraged loan, but many are identified by credit ratings below investment grade or based on margin levels over a floating interest rate benchmark.
*   Investment funds may include leveraged loans in their portfolios for higher potential returns due to their attractive interest rates, despite the associated risks.

## How Leveraged Loans Work and Are Structured

At least one commercial or investment bank structures, arranges, and administers a leveraged loan. These institutions are called arrangers and subsequently may sell the loan, in a process known as [syndication](https://www.investopedia.com/terms/s/syndicate.asp), to other banks or investors to lower the risk to lending institutions.

No fixed rules define a leveraged loan. Some market participants base it on a spread. For instance, many of the loans pay a [floating rate](https://www.investopedia.com/terms/f/floatinginterestrate.asp), often based on the Secured Overnight Financing Rate (SOFR), which replaced the [London Interbank Offered Rate (LIBOR)](https://www.investopedia.com/terms/l/libor.asp) in June 2023, or another benchmark, plus a stated basis or [ARM margin](https://www.investopedia.com/terms/a/armmargin.asp). In general, the adjustment of the credit spread adds basis points to the interest rate on a loan to make up for the fact that SOFR has traded below LIBOR.

If the ARM margin is above a certain level, it is considered a leveraged loan. Others base the classification on the borrower's credit rating, with loans rated below [investment grade](https://www.investopedia.com/ask/answers/what-does-investment-grade-mean/), which is categorized as Ba3, BB-, or lower by the rating agencies [Moody's](https://www.investopedia.com/terms/m/moodys.asp) and [S&P Global Ratings](https://www.investopedia.com/terms/s/sp.asp).

Typically, banks are allowed to change the terms when syndicating the loan, which is called price flex. The ARM margin can be raised if demand for the loan is insufficient at the original interest level, in what is referred to as upward flex. Conversely, the spread over SOFR can be lowered, which is called reverse flex, if demand for the loan is high.

## Leveraged Loans: Business Applications and Strategic Uses

Companies typically use a leveraged loan to finance [mergers and acquisitions](https://www.investopedia.com/terms/m/mergersandacquisitions.asp) (M&A), recapitalize the balance sheet, refinance debt, or for general corporate purposes.

M&A could take the form of a [leveraged buyout](https://www.investopedia.com/terms/l/leveragedbuyout.asp) (LBO). An LBO occurs when a company or private equity company purchases a public entity and takes it private. Typically, debt is used to finance a portion of the purchase price. A recapitalization of the balance sheet occurs when a company uses the capital markets to change the composition of its capital structure. A common transaction in this process issues debt to buy back stock or pay a [dividend](https://www.investopedia.com/terms/d/dividend.asp), which are cash rewards paid to shareholders.

> **Fast Fact**
>
> Leveraged loans allow companies or individuals that have high debt or poor credit history to borrow cash, though at higher interest rates than usual.

## Real-World Examples of Leveraged Loans

[Credit rating agencies](https://www.investopedia.com/articles/bonds/09/history-credit-rating-agencies.asp) like Moody's or S&P Global Ratings typically identify loans as leveraged if they are rated below instrument grade. Moody's defines leveraged debts as those rated Ba3 or lower, while S&P categorizes leveraged loans as those rated BB- or lower.

## What Is a Leveraged Loan?

A leveraged loan is a type of loan made to borrowers with high levels of debt or a low credit rating. Lenders consider leveraged loans to carry a higher-than-average risk that the borrower will be unable to pay back the loan (also known as the risk of default). These loans generally earn higher interest rates for lenders because of the higher level of risk.

## What Is the Difference Between a Bank Loan and a Leveraged Loan?

Leveraged loans—also known as floating-rate loans or bank loans—are loans made by banks or other financial institutions that are then sold to investors. Companies may use the money they get to refinance their debt, fund mergers and acquisitions, or finance projects. The companies that receive these loans typically have credit ratings that are below investment grade. They are secured by collateral such as the borrower's real estate and equipment, or by [intellectual property](https://www.investopedia.com/terms/i/intellectualproperty.asp), including brands, trademarks, and customer lists.

## How Do Funds Invest in Leveraged Loans?

Investment funds (such as [mutual funds](https://www.investopedia.com/terms/m/mutualfund.asp) and exchange-traded funds, or ETFs) may hold leveraged loans in their portfolios, depending on their investment strategy. Some funds may make a small investment in leveraged loans as part of a diversified portfolio, while others might invest heavily in these loans. Fund portfolio managers may be interested in purchasing these loans because their higher interest rates could mean a higher return for investors in the fund.

## The Bottom Line

Leveraged loans are offered to entities with substantial debt or poor credit, carrying higher risks of default. Consequently, these loans entail higher interest rates, reflecting this risk. These loans lack strict defining criteria and often involve a floating rate based on the Secured Overnight Financing Rate (SOFR) plus an ARM margin. Companies frequently utilize leveraged loans for financing mergers and acquisitions, refinancing debt, or general corporate purposes. Understanding these loans is crucial for making informed financial decisions, especially given their inherent risks and costs.

> **Article Sources**
>
> 1.  Investor.gov. "[Leveraged Loan Funds—Investor Bulletin](https://www.investor.gov/introduction-investing/general-resources/news-alerts/alerts-bulletins/investor-bulletins/leveraged)."
>     
> 2.  The Wall Street Journal. "[Companies, Lenders Clash Over Loan Spreads in Switch From Libor](https://www.wsj.com/articles/companies-lenders-clash-over-loan-spreads-in-switch-from-libor-11673570660)." (Subscription required.)
>     
> 3.  Federal Deposit Insurance Corporation. "[Leveraged Lending: Evolution, Growth, and Heightened Risk](https://www.fdic.gov/regulations/examinations/supervisory/insights/sifall19/sifall2019-article02.html)."
>     
> 4.  Fidelity. "[An Opportunity for Income Seekers](https://www.fidelity.com/learning-center/trading-investing/leveraged-loans-outlook)."