What are leveraged loans?

A leveraged loan is a type of loan extended to companies or individuals that already have significant amounts of debt. These loans are considered higher risk for lenders due to the borrower's existing debt level, hence they usually carry higher interest rates to compensate for the increased risk.

Leveraged loans are often used in leveraged buyouts (LBOs) to acquire companies. In such cases, the loans are structured to be senior and collateralized, which means they have priority in repayment and are secured by the borrower's assets. They typically feature floating interest rates, which can fluctuate, rather than fixed rates, providing some protection to lenders against interest rate increases 1.

Additionally, leveraged loans often end up in Collateralized Loan Obligations (CLOs), which are packages of loans sold to investors in tranches. This means that cash flows are distributed according to investment priority, with higher-rated (lower-risk) tranches paid first 1 2.

Leverage in finance allows entities to control larger assets with a smaller amount of personal capital, amplifying potential gains but also increasing risks significantly if the investments do not perform well 3.