What are leveraged loans?

Leveraged loans are syndicated bank loans extended to companies that carry significant debt burdens, typically defined as having leverage ratios above 4x debt-to-EBITDA or credit ratings below investment grade. Unlike high-yield bonds, which are fixed-rate and unsecured, leveraged loans are floating-rate (coupon resets periodically based on SOFR plus a spread) and are usually secured by the borrower's assets, giving lenders priority in bankruptcy.

The leveraged loan market has grown dramatically since the 2008 financial crisis, reaching approximately $1.4 trillion in outstanding volume. This growth was fueled by private equity firms using leveraged loans to finance acquisitions (leveraged buyouts), by companies refinancing existing debt, and by strong investor demand for floating-rate assets during the low-rate era. The floating-rate feature was particularly attractive during rising-rate environments because loan coupons increase alongside Fed rate hikes, protecting investors from duration risk.

However, this floating-rate feature creates a different risk: as rates rose rapidly in 2022-2023, borrowers' interest expenses surged, straining cash flows. Companies that were comfortably servicing debt when SOFR was 0.5% suddenly faced much larger interest bills at SOFR above 5%. This rate sensitivity means that leveraged loan default rates tend to spike during periods of both rising rates and slowing growth, the combination most dangerous for highly leveraged borrowers.

The leveraged loan market is closely connected to the collateralized loan obligation (CLO) market, as CLOs are the largest buyers of leveraged loans, holding approximately 70% of institutional leveraged loans. This interconnection means that stress in the leveraged loan market can transmit to CLO investors, while CLO issuance dynamics can affect the supply-demand balance for leveraged loans. Monitoring leveraged loan prices, new issuance volumes, and default rates provides insight into credit cycle conditions for the most leveraged segment of corporate America.