Module 25
Leveraged loans
A leveraged loan is a loan to a below-investment-grade company — typically one carrying private-equity-style debt loads — that a bank arranges and then syndicates out to institutional buyers. Two words define the product: senior secured (first claim on the company's assets) and floating rate(the coupon resets with short-term rates). If you've heard of loans at all, it's probably because they are the raw material of CLOs — roughly two-thirds of the loan market sits inside CLOs (Module 5 covers that machine).
The mechanics:
- Floating coupon — the loan pays SOFR + spread, resetting every few months. Because the coupon moves with rates, the price barely does: duration is roughly zero.
- Senior secured — a first lien on the company's assets means loan holders get paid first in bankruptcy. Historical recoveries ran 60–70%+, versus ~40% for unsecured bonds of the same issuer.
- Cov-lite — most loans today carry few maintenance covenants, so lenders can't intervene early when a borrower deteriorates; they find out at default.
- Prepayable near par — borrowers can repay at ~100 with only soft-call protection, so a loan has little upside above par. When markets rally, you get refinanced, not rich.
What moves the P&L: with rates passing straight through the coupon, default and recovery are the whole game. Three things complicate it. First, recovery erosion— cov-lite documents plus “liability management” maneuvers (assets shifted beyond lenders' reach, one creditor group primed by another — the trade press calls it creditor-on-creditor violence) have pushed recent recoveries below the historical 60–70%. Second, liquidity — loans settle in roughly T+20, not T+1, a real constraint when everyone wants out at once. Third, repricing risk — in strong markets issuers simply call and refinance their spread down, clipping your income at exactly the moment everything else is rallying.
The metrics on every loan desk: the spread or discount margin, the price (par = 100), the annual default rate (CDR), realized recoveries, the share of the market that is cov-lite, and CCC exposure — the tail of borrowers closest to trouble.
The takeaway: a leveraged loan is floating-rate, senior-secured credit— no duration, all default-and-recovery risk, with recoveries drifting below the historical 60–70% as cov-lite and liability management bite. It's the collateral every CLO conversation starts from. Dial in the economics below.
🎛 Loan economics lab
Gross coupon
8.00%
SOFR + spread
Expected credit loss
−0.70%
CDR × (1 − recovery)
Net expected yield
7.30%
what you keep after defaults
The seniority benefit
Loss at 65% recovery
70 bp
Loss at 40% (unsecured bond)
120 bp
Seniority saves
+50 bp/yr
Same defaults, same issuer — the first lien on assets is what turns a given default rate into a smaller loss. Drag recovery down toward 40% and watch the advantage disappear.
Duration ≈ 0: the coupon resets with SOFR every few months, so when rates move the coupon moves with them — the price barely reacts. All the risk lives in the default and recovery sliders.
The gross coupon is what the loan pays while it performs; the expected credit loss is the long-run drag from defaults at your assumed recovery; the difference is the yield you actually expect to keep. Real portfolios also face prepayments, repricings and trading costs. Educational tool — not investment advice.
How the loan economics are computed
The lab strips a loan down to income minus losses:
gross coupon (%) = SOFR + spread / 100 expected loss (%) = CDR × (1 − recovery) net expected yield (%) = gross coupon − expected loss
Worked example: with SOFR at 4.5% and a 350bp spread, the loan pays 4.5 + 3.5 = 8.0%. At a 2% CDR and 65% recovery, defaults cost 2% × 35% = 0.70% a year, leaving a 7.30% net expected yield. Run the same defaults at a bond-style 40% recovery and the loss jumps to 1.20% — the first lien is worth 50bp a year in this example, which is exactly the seniority row in the widget.
Things to try
- • Move SOFR from 1% to 6% — the gross coupon tracks it one-for-one. That pass-through is why duration ≈ 0.
- • Set a recession: CDR 8%, recovery 45% — watch the net yield collapse even though the coupon never moved.
- • Compare recovery 65% vs 40% at any CDR — the seniority row shows what the first lien is worth, and what erodes as cov-lite bites.
- • Try a B-rated profile (spread 400bp, CDR 3%) against a BB profile (spread 250bp, CDR 1%) — which nets more?