Leveraged loan issuers are capitalizing on strong investor demand to push for provisions that would lower their future borrowing costs and give them a buffer if the Federal Reserve keeps interest rates elevated.

They’re increasingly asking to add so-called step-down clauses within their loans, which could reduce their interest rates - often by a quarter of a percentage point - if they meet certain targets. These goals typically include an initial public offering, a credit-rating upgrade or a company reducing its debt load.

In June, 15 leveraged loan transactions that priced featured step-down provisions, the most this year and the largest amount since January, which saw 10 such deals, according to data compiled by Bloomberg. Payment processor Worldpay Inc. was able to add terms that would allow it to cut its margins on two facilities if it goes public. Insurance broker Ardonagh and more recently KKR & Co.-backed BMC Software snagged similar concessions contingent on their respective goals.

An imbalance between supply and demand has given borrowers more room to negotiate better terms with lenders, said John McAuley, Citigroup’s head of North America debt capital markets.

“When you have a good transaction in this market you can embed more issuer-friendly options in it than when the market is balanced,” he said.

Step-downs are just one way that companies and often their private equity owners are coping with elevated borrowing costs that have stung issuers exposed to floating-rate debt. Companies have also been repricing their debt this year - lowering margins on a loan without tying it to a target - saving over $1 billion in annual interest expenses through the end of May.

About 90% of the $743 billion of leveraged loan issuance so far this year involves refinancing or repricing, according to data compiled by Bloomberg. Several repricing deals have included step-down provisions. Given the slim pickings in the leveraged loan market, investors - the largest of them being collateralized loan obligations - are reluctant to turn down such deals because they may not have replaceable assets.

Investor appetite is perhaps best underscored in the case of Worldpay. The company tapped the market in June to reprice its $5.2 billion and €500 million leveraged loans issued last year. Given the demand for its debt transaction this year, it was able to add back the step-down it had removed for the dollar portion during the marketing process for the loans last September.

Both Ardonagh’s deal in June and BMC Software’s transaction this month included step-downs tied to a leverage target. BMC’s step-down for all three of its facilities also hinges on it completing an initial public offering.

Another feature during strong markets is portability, which allows a buyer of a company to keep its existing debt package in place, Citigroup’s McAuley said. Adding a portability clause to transactions that involve step-down provisions makes it easier to sell the company later because the new owner doesn’t have to find fresh financing.

Step-downs may not be ideal for companies pursuing acquisitions or looking to issue debt to fund dividends, said Sinjin Bowron, portfolio manager at Beach Point Capital. There’s also little protection for lenders due to loans not having having a call schedule that requires bonds to be redeemed at a higher price before maturity.

The step-down provision “shows an inclination to deleverage and diversify sources of funding but there’s no protection for lenders in that process,” Bowron said. The repricing wave is already lowering investors’ overall returns, and step-downs would lower them even further, he added.

While a positive event for a company could trigger the step-down clause, lenders would end up taking a hit because the margin they’re paid gets reduced. If the Fed cuts interest rates soon, returns could be pressured further.

  - Bloomberg