Leveraged Loans are typical corporate bonds, so-called because the issuing companies tend to already have a good deal of debt outstanding. Leveraged Loans are also known as floaters, because their interest rates are generally tied to an index.
Q. Well, right off the bat, that sounds like a completely redundant title.
A. Yes, the lingo of Wall Street isn’t exactly crystal clear all the time. These are just corporate loans… the name is meant to imply that they’re issued by companies that already have a lot of debt outstanding (rather like mezz debt). They’re also called floaters, because generally the interest rates are set off an index and move with overall rates.
Q. So, for investors, what’s the attraction?
A. Two. First, very generally, the yields are roughly comparable to junk bonds; but, second, the interest reset mechanism makes them much safer from interest-rate risk. In the ongoing, big hunt for yield with minimal duration risk, that’s made them very popular lately.
Q. And the risks are…
A. Almost by definition, then, they carry higher credit risk than traditional bonds, so if the economy falters (again) they could see a higher than typical default rate. Of course, investors are compensated for that with meaningfully higher rates.
Q. So… you’re sort of trading credit risk for duration risk?
A. Definitely one way to look at it. The interesting thing about that is that it’s very hard to get paid for duration risk in this market… but you can get paid to take credit risk. These instruments are therefore interesting because they don’t have much of the risk that you’re not going to get paid for; and you are being compensated for the risk they do have.
Q. So how does someone invest?
A. These loans are purely “over the counter” type instruments– they’re non-standard and don’t trade, and it can take weeks to find a buyer for a given instrument. In addition, they can require care and feeding– for example, holders are often asked to agree to some changes in the underlying terms (aka “covenants”). Therefore, they have largely been the provenance of institutional buyers; but now mutual funds have specialized in the space for years, and that number has grown; and in the latest twist, several so-called actively managed ETFs have hit the market (to a great response).