Why are leveraged loans typically structured as floating-rate instruments?

Question

BlackTom AI · Accepted Answer

The question asks: Why are leveraged loans typically structured as floating-rate instruments?
Since the answer options are not provided in the data, we can only analyze the concept and the single statement offered in the 'answer' field, which is: 'To reduce interest rate risk for lenders while maintaining credit exposure.'
First, consider what a floating-rate instrument implies. A loan with a floating or variable interest rate adjusts its coupon periodically based on a reference rate (such as LIBOR or SOFR) plus a credit spread. This means that when benchmark rates rise, the loan’s interest payments rise as well, and when benchmark rates fall, payments decrease accordingly. This mechanism directly affects interest rate risk—the risk that changing rates will affect the loan’s value or the lender’s returns.
Now, applying this to leveraged loans, which are typically issued to below-investment-grade borrowers and are often secured with collateral: the floating-rate feature helps lenders hedge against rising base interest rates. If market rates go up, the coupon on the loan increases, helping lenders preserve a portion of their expected yield. Conversely, as rates fall, the coupon declines, but the structured credit exposure and the collateral-backed nature of many leveraged loans help maintain credit risk control and recovery prospects for lenders.
Therefore, the conventional rationale is that floating-rate structuring reduces interest rate risk for lenders without eliminating credit exposure to the borrower’s default risk. This aligns with the statement provided in the answer field.
However, to fully validate this as the correct choice, one would typically compare it against other possible explanations such as differences in liquidity, covenant features, or refinancing risk. Since no additional options are present to contrast, we cannot assess alternatives here. In general, the floating-rate design’s primary appeal is the alignment of coupon adjustments with prevailing interest rates, which mitigates rate-driven volatility for lenders while preserving the intended credit exposure to the borrower’s performance.
In summary, the reasoning behind the floating-rate structure is that it helps lenders resist fluctuations in base interest rates (reducing interest rate risk) while keeping the borrower credit risk profile intact, which matches the provided statement under typical explanations for leveraged loans.

BU.231.710.51.FA25 PoP Quiz - 2 (Week 5)

Why are leveraged loans typically structured as floating-rate instruments?

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