By Helle Pilia, Head of Client Service Delivery, Loan Administration
Leveraged loans offer investors a unique opportunity for higher yields, and the market is steadily gaining steam. In Europe, the leveraged loan market closed Q3 2024 with record year-to-date activity, exceeding 2021’s full-year total.
However, this potential upside comes with distinct risks and considerations. In this guide, we’re breaking down what leveraged loans are, how they work, and how to determine whether they’re a good fit for your investment portfolio.
What is a leveraged loan?
A leveraged loan is a type of loan extended to borrowers—either companies or individuals—who already carry substantial debt or have a low credit rating. These loans typically come with higher interest rates due to the risk of default, increasing both risk and reward for lenders.
Leveraged loans are structured and administered by commercial or investment banks known as “arrangers.” Arrangers may sell the loan or portions of the loan to other banks or investors, mitigating risk through a process known as syndication. The European Leveraged Loan Index and S&P Global Leveraged Loan Index track leveraged loan performance, offering insights into trends and expected returns.
What is the difference between direct lending and leveraged loans?
Leveraged loans and direct lending share some similarities, but they are distinct in a few key ways:
- Direct lending is provided directly to borrowers by private asset managers, thereby bypassing traditional lenders. These loans generally offer less liquidity but higher yields
- Leveraged loans are usually syndicated, meaning they are tradeable securities available in the public market. As discussed, leveraged loans also originate from traditional bank lenders
While leveraged loans are publicly traded and accessible to a broader range of investors, direct lending is more private and illiquid, offering higher yields but less flexibility.
Essential considerations for leveraged loans
Investing in leveraged loans requires a clear understanding of a few factors, including credit risk, interest rate risk, and liquidity.
- Credit risk: Leveraged loans are more likely to default due to the borrower’s financial profile
- Interest rate risk: Many leveraged loans carry floating interest rates, which can introduce unpredictability
- Liquidity: While leveraged loans are tradeable, they can still be more challenging to liquidate than traditional loans or bonds
How leveraged financing works
“Leveraged finance” is the practice of using a higher-than-normal amount of debt to finance investments. Private equity and leveraged buyout firms often use this strategy to enhance returns for investors.
The core benefit of this approach is that the effective cost of debt is cheaper than equity and can amplify returns if the investment performs well. However, a highly leveraged loan increases earnings volatility, cash flow unpredictability, and sensitivity to market fluctuations such as interest rates.
Our range of loan solutions
At IQ-EQ, we deliver tailored loan services that align with your investment goals. From structuring leveraged loans to comprehensive direct lending support, our expertise ensures seamless management across the lending lifecycle. Whether you’re new to leveraged loans or looking to optimise your portfolio, our team of specialists is here to help.
Speak with our team of loan service experts to learn more.
