LIBOR Floors in Leveraged Loans

Abstract

I examine the use of LIBOR floors in U.S. leveraged (syndicated) loans. These options, rare prior to 2008, provide a minimum interest rate on these otherwise floating rate loans. This contract design is consistent with theory suggesting lenders prefer more fixed rate assets while interest rates are low in order to cover their fixed costs. Two main findings support this rationale. First, borrowers seeking to extend loans between 2009 and 2016 were able to attract 34% more principal from lenders if a floor was added, suggesting demand for floors originated from the supply of credit. Second, banks that participated in floor-adjusted credit lines had significantly higher fixed costs than did banks in purely floating rate facilities. Floors are concentrated in institutional facilities, in particular those that are most likely to trade in the secondary market. This is consistent with cost savings associated with embedded floors over those obtained through third-parties when expected trading volume is high. Consistent with their theoretically higher interest rate sensitivity, loans that embed floors are more likely to include call protection, in the form of cancellation and upfront fees. Floors represent a significant component of loan pricing, contributing three to five times as much as upfront fees to total lender compensation.