Credit Market Vocabulary and Definitions

Introduction

• Credit markets have developed specialized terminology
• Describing instruments, processes, metrics, and concepts essential to leveraged finance
• Understanding this vocabulary enables effective communication with market participants
• And comprehension of credit documentation and financing structures

SOFR (Secured Overnight Financing Rate)

Definition:

• A benchmark interest rate representing the cost of borrowing cash overnight
• Collateralized by U.S. Treasury securities
• It replaced LIBOR as the primary reference rate for U.S. dollar-denominated loans

SOFR (Secured Overnight Financing Rate)

Background:

• LIBOR (London Interbank Offered Rate) was discontinued for U.S. dollars
• At the end of June 2023 following manipulation scandals
• Markets needed a robust alternative based on actual transactions rather than estimated rates

SOFR (Secured Overnight Financing Rate)

Calculation:

• Published daily by the Federal Reserve Bank of New York
• Based on overnight repurchase agreement (repo) transactions in the Treasury repo market
• Representing actual borrowing costs rather than surveyed estimates

SOFR (Secured Overnight Financing Rate)

Term SOFR:

• Since loans require forward-looking rates for interest periods (typically 1-month, 3-month, or 6-month)
• Term SOFR provides these tenors derived from SOFR futures and derivatives markets
• Most leveraged loans now reference Term SOFR

SOFR (Secured Overnight Financing Rate)

Credit Adjustment Spread (CAS):

• When transitioning from LIBOR to SOFR, markets added credit adjustment spreads
• Typically 10-11 basis points for 1-month, 26 basis points for 3-month
• To account for structural differences, ensuring borrowers faced similar all-in costs

SOFR (Secured Overnight Financing Rate)

Rate Floors:

• Many loan agreements include SOFR floors (commonly 0.50% to 1.00%)
• Ensuring minimum base rates even when SOFR approaches zero
• Total interest equals the greater of SOFR or the floor, plus the credit spread

SOFR (Secured Overnight Financing Rate)

Usage in Documentation:

• Loan agreements specify "Term SOFR plus [margin]"
• Or "SOFR plus [credit adjustment spread] plus [margin]" as the interest rate
• With defined conventions for calculation and payment

Basis Points (bps)

Definition:

• A basis point is one-hundredth of one percent (0.01%)
• Or 1/100th of 1%
• Provides a standardized way to express small differences in interest rates, yields, or spreads

Basis Points (bps)

Conversion:

• 100 basis points equal 1.00%
• 50 basis points equal 0.50%
• And 25 basis points equal 0.25%
• This allows precise discussion of rate changes without cumbersome decimal expressions

Basis Points (bps)

Usage Examples:

• A loan priced at "SOFR plus 350 bps" means the spread is 3.50%
• If SOFR is 5.25%, the all-in rate is 8.75% (5.25% + 3.50%)
• A pricing improvement from 400 bps to 375 bps represents a 25 basis point reduction

Basis Points (bps)

Market Convention:

• Credit markets universally use basis points rather than percentages
• When discussing spreads, fees, or rate changes
• Making this terminology essential for clear communication

Basis Points (bps)

Why It Matters:

• Basis points eliminate ambiguity
• Saying "increase the rate by 0.5%" could mean adding 50 bps (from 5.0% to 5.5%)
• Or multiplying by 1.005 (from 5.0% to 5.025%)
• Saying "increase by 50 bps" is unambiguous

Floating vs. Fixed Rate

Floating Rate Definition:

• Interest rates that adjust periodically based on changes in an underlying benchmark rate
• (SOFR, EURIBOR, etc.)
• Meaning borrowers' interest costs fluctuate with market conditions

Floating vs. Fixed Rate

Floating Rate Mechanics:

• A floating-rate loan might be priced at "3-month Term SOFR + 400 bps"
• Every three months, the loan reprices using the then-current 3-month SOFR rate
• Plus the fixed 400 basis point spread, so total interest changes as SOFR moves

Floating vs. Fixed Rate

Floating Rate Advantages:

• Borrowers benefit if benchmark rates decline (lower interest costs)
• While lenders are protected from inflation and rising rate environments
• Floating rates also typically start lower than equivalent fixed rates

Floating vs. Fixed Rate

Floating Rate Risks:

• Borrowers face uncertainty in debt service costs
• And vulnerability to rising rates, potentially straining cash flow
• Budgeting becomes more difficult when interest expense varies quarterly

Floating vs. Fixed Rate

Fixed Rate Definition:

• Interest rates that remain constant throughout the loan or bond's life
• Providing payment certainty
• Regardless of market rate movements

Floating vs. Fixed Rate

Fixed Rate Mechanics:

• A fixed-rate bond with a 7.50% coupon pays exactly 7.50% annually
• Regardless of whether market rates rise to 10% or fall to 4%
• The rate is locked at issuance and never changes

Floating vs. Fixed Rate

Fixed Rate Advantages:

• Borrowers gain payment predictability
• And protection if market rates rise
• Companies can lock in attractive rates during low-rate environments for extended periods

Floating vs. Fixed Rate

Fixed Rate Risks:

• Borrowers cannot benefit from rate declines without refinancing
• (which may involve prepayment penalties)
• And fixed rates typically price higher than floating rates
• To compensate lenders for interest rate risk

Floating vs. Fixed Rate

Market Conventions:

• Leveraged loans are predominantly floating rate (95%+ of the market)
• While high-yield bonds are typically fixed rate
• This creates natural market segmentation based on borrower preferences

Floating vs. Fixed Rate

Interest Rate Swaps:

• Borrowers with floating-rate debt can use interest rate swaps
• To convert floating obligations into synthetic fixed rates, and vice versa
• Allowing them to choose their preferred rate structure after initial borrowing

Leveraged Loan

Definition:

• Bank debt extended to companies rated below investment grade (BB+ or lower)
• Or debt that, when combined with other obligations
• Results in high leverage ratios typically exceeding 4.0x debt-to-EBITDA

Leveraged Loan

Market:

• Leveraged loans are syndicated to institutional investors
• Including CLOs, loan mutual funds, and insurance companies
• Rather than being held entirely by originating banks

Key Features:

• Typically secured by company assets
• Floating rate (SOFR-based), senior ranking in capital structure
• And covenant protections (though covenant-lite has become prevalent)

Spread

Definition:

• The margin or additional interest rate charged above the benchmark rate (SOFR)
• Representing compensation for credit risk, liquidity
• And transaction-specific factors

Spread

Pricing Grid:

• Some facilities include grids where spreads adjust based on leverage ratios
• Spreads decline as leverage improves
• And increase as leverage deteriorates
• Typically varying by 25-50 basis points per leverage level

Senior Secured

Definition:

• Debt holding first-priority claims on borrower assets
• Ranking ahead of all other creditors
• In bankruptcy or liquidation scenarios
• Security is provided through liens on substantially all company assets

Senior Secured

Priority:

• Senior secured lenders receive repayment before unsecured creditors
• Subordinated debt holders, and equity investors
• Providing downside protection through collateral access

Senior Secured

Collateral Package:

• Typically includes accounts receivable, inventory, equipment
• Intellectual property, real estate
• And equity interests in subsidiaries
• Documented through security agreements and UCC filings

Syndication

Definition:

• The process of distributing debt among multiple lenders
• Allowing arranging banks to reduce concentration risk
• And enabling smaller institutions to participate in large financings

Syndication

Lead Arrangers:

• Banks that underwrite and structure transactions
• Commit to full financing amounts
• Then market and distribute portions to other lenders
• While retaining meaningful positions themselves

General Syndication:

• Distribution to broader lender groups after lead arrangers commit
• With allocations based on lender demand, relationship strength
• And arranger discretion within overall size constraints

Covenant-Lite (Cov-Lite)

Definition:

• Loan structures lacking traditional financial maintenance covenants
• That require quarterly compliance with leverage or coverage ratios
• Instead, cov-lite loans include only incurrence covenants
• Restricting specific actions

Covenant-Lite (Cov-Lite)

Prevalence:

• Now represents over 90% of institutional term loan issuance
• Marking fundamental shift from pre-2008 markets
• Where maintenance covenants were standard

Implications:

• Provides borrowers operational flexibility
• Eliminates technical default risk from financial underperformance
• But reduces lender early-warning mechanisms and intervention rights

Amortization

Definition:

• Scheduled principal repayment over a loan's life
• Reducing outstanding balances gradually
• Rather than repaying entirely at maturity

Amortization

Term Loan A:

• Typically amortizes 5-20% annually in graduated schedules
• Fully repaying by maturity

Term Loan B:

• Minimal amortization of just 1% annually
• With 99% of principal due at maturity in balloon payment

Amortization

Purpose:

• Amortization reduces lender exposure over time
• Demonstrates deleveraging progress
• And lowers refinancing risk
• By reducing amounts due at maturity

EBITDA

Definition:

• Earnings Before Interest, Taxes, Depreciation, and Amortization
• A measure of operating profitability
• Removing capital structure, tax, and non-cash accounting impacts

EBITDA

Calculation:

• Start with net income
• Add back interest expense, tax expense
• Depreciation, and amortization
• To arrive at operating cash generation proxy

EBITDA

Credit Agreements:

• Define EBITDA specifically
• Typically permitting adjustments for non-recurring items
• Restructuring costs, stock compensation
• And sometimes pro forma acquisition synergies (subject to caps)

EBITDA

Usage:

• Primary metric for calculating leverage ratios (Debt/EBITDA)
• Coverage ratios (EBITDA/Interest)
• And establishing covenant levels in credit agreements

Original Issue Discount (OID)

Definition:

• When debt issues at less than par value (face amount)
• Typically 98-99% of par
• Creating immediate yield enhancement for investors
• While maintaining stated interest rates

Original Issue Discount (OID)

Example:

• A $100 million loan issued at 98%
• Provides borrowers only $98 million in proceeds
• But requires repayment of full $100 million at maturity
• Creating additional 2% return for lenders

Accounting:

• Treated as additional interest expense amortized over the loan term
• Rather than immediate expense
• Affecting both GAAP earnings and taxable income

Collateralized Loan Obligation (CLO)

Definition:

• Structured finance vehicles that purchase portfolios of leveraged loans
• Funded through issuance of tranched debt securities
• With varying risk-return profiles

Collateralized Loan Obligation (CLO)

Market Importance:

• CLOs represent 60-70% of institutional term loan investor base
• Making them the dominant force
• Driving leveraged loan market liquidity and demand

Structure:

• Issue AAA through equity tranches
• Using senior tranche proceeds to buy diversified loan portfolios
• Interest income from loans distributed to tranches based on seniority
• With excess spread flowing to equity

Make-Whole Premium

Definition:

• Prepayment penalty calculated to compensate lenders
• For lost interest through maturity
• Using present value of remaining payments
• Discounted at Treasury rates plus specified spreads

Make-Whole Premium

Purpose:

• Protects lenders from prepayment during initial years
• When they expect to earn returns on committed capital
• Particularly important in bond markets

Calculation:

• Determine present value of all remaining interest and principal payments
• Using discount rate of comparable Treasury yield plus 50 basis points (typical)
• Prepayment amount is the greater of this value or par

All-In Yield

Definition:

• Total return to investors including stated interest rate
• SOFR floor value, original issue discount, and upfront fees
• Expressed as annualized percentage

All-In Yield

Example:

• SOFR + 400 basis points
• With 1% OID and 50 basis point SOFR floor
• When actual SOFR is 0.25%
• Creates all-in yield exceeding the stated 400 basis point spread

Usage:

• Enables comparison across different loan structures
• With varying fee and OID components
• Showing true economic returns to investors

Commitment

Definition:

• Amount that lenders agree to make available to borrowers
• Representing maximum potential exposure
• Rather than necessarily outstanding balances

Commitment

Revolving Facilities:

• Commitments represent maximum borrowing capacity
• With actual usage fluctuating based on borrower needs
• Unused commitment fees compensate lenders for availability

Commitment

Term Loans:

• Commitments equal initial funding amounts for term loans
• With amortization or prepayments
• Reducing outstanding amounts below original commitments

Par / Discount / Premium

Definition:

• Loan and bond pricing relative to face value
• Where par equals 100%, discount means below 100% (e.g., 98)
• And premium means above 100% (e.g., 102)

Par / Discount / Premium

Trading Levels:

• Performing credits typically trade near par (98-102)
• While distressed credits trade at substantial discounts (50-80 or below)
• Reflecting default probability and recovery expectations

Par / Discount / Premium

Quotation:

• Secondary market loans quote as dollar prices (e.g., "98.50")
• Plus accrued interest
• Transactions settle at quoted price times par amount
• Plus interest accrued since last payment date

Administrative Agent

Definition:

• Lender designated to handle facility administration
• Including payment processing, notice distribution, compliance monitoring
• And coordination among lender groups

Administrative Agent

Responsibilities:

• Collect and distribute payments
• Monitor borrowing base compliance (in ABL facilities)
• Maintain lender records and coordinate amendments
• Serve as primary borrower contact

Administrative Agent

Fees:

• Receives annual administrative fees
• Compensating for operational duties
• Typically $25,000-100,000 annually
• Depending on facility size and complexity

Financial Sponsor

Definition:

• Private equity firms and similar institutional investors
• That acquire companies using leveraged buyout structures
• Distinguished from strategic acquirers who are operating companies

Financial Sponsor

Characteristics:

• Raise funds from limited partners
• Acquire portfolio companies and implement operational improvements
• Exit investments within defined timeframes
• Targeting specific return thresholds

Financial Sponsor

Market Impact:

• Sponsor-backed deals represent significant portion of leveraged finance volume
• Established sponsors often receive better financing terms
• Due to track records and repeat business

Cross-Default

Definition:

• Provision making default under other debt agreements
• An event of default under the subject credit facility
• Preventing selective defaults and protecting lender interests

Cross-Default

Thresholds:

• Typically apply only to material debt
• Defined as obligations exceeding specified amounts
• (e.g., $25-50 million)
• To avoid technical defaults from immaterial payment failures

Cross-Default

Purpose:

• Ensures lenders aren't subordinated
• Through borrower defaults on other obligations
• While maintaining current status on the subject facility

Covenant Headroom

Definition:

• The cushion or buffer between actual financial metrics
• And maximum permitted levels under maintenance covenants
• Typically expressed as percentages or absolute differences

Covenant Headroom

Example:

• If actual leverage is 4.2x and maximum permitted is 5.0x
• Headroom is 0.8x or approximately 16%
• Indicating how much performance can deteriorate
• Before covenant breach

Covenant Headroom

Management:

• Borrowers monitor headroom continuously
• Maintaining adequate cushions (typically 10-15% minimum)
• To absorb business volatility
• Without triggering technical defaults

Material Adverse Change (MAC)

Definition:

• Significant negative development affecting borrower's business
• Financial condition, or repayment ability
• Potentially allowing lenders to refuse advances or accelerate obligations

Material Adverse Change (MAC)

Enforceability:

• MAC clauses are notoriously difficult to enforce
• Absent clear, substantial, and sustained deterioration
• With most situations falling short of MAC thresholds

Material Adverse Change (MAC)

Acquisition Financing:

• "Certain funds" provisions in LBO financings
• Eliminate MAC-based funding conditions during specified periods
• Ensuring acquisition financing certainty
• Regardless of market changes

Waterfall

Definition:

• Priority order for distributing cash flows or asset sale proceeds
• Among creditor classes, with senior obligations receiving payment before junior claims

Waterfall

Payment Waterfall:

• Operating cash flows typically pay senior debt interest
• Then junior debt interest
• Then senior principal, then junior principal
• Then equity distributions

Waterfall

Liquidation Waterfall:

• Asset sale proceeds pay administrative expenses, senior secured debt
• Second lien debt, unsecured debt, subordinated debt, then equity
• With each tier paid fully
• Before next tier receives anything

Conclusion

• Mastering credit market vocabulary enables effective participation in leveraged finance markets
• Comprehension of complex documentation
• And clear communication with transaction participants

Conclusion

• These fundamental terms appear repeatedly in credit agreements
• Marketing materials, and market discussions
• Understanding SOFR's role as the benchmark rate, the precision of basis points

Conclusion

• The distinction between floating and fixed rate structures
• Leverage concepts like covenant-lite structures and amortization profiles
• Valuation metrics including EBITDA and all-in yield

Conclusion

• And structural concepts like syndication and waterfalls
• Provides essential foundation for understanding leveraged finance

Conclusion

• As markets evolve and introduce new products or terminology
• These core concepts remain relevant, serving as building blocks
• For understanding more sophisticated structures and market developments