Loan Stock

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Loan Stock Explained

Overview

Loan stock is an arrangement in which shares (common or preferred) are used as collateral to secure a loan. Functionally it resembles a traditional loan—borrower receives cash and pays fixed interest—but the lender holds equity as security. Loan-stock arrangements can be secured or unsecured and may include convertible features.

How it works

  • The borrower pledges publicly traded, unrestricted shares that are relatively easy to sell if the borrower defaults.
  • Lenders typically take physical or legal control of the shares for the loan duration. When the loan is repaid, the shares are returned.
  • Lenders set a loan-to-value (LTV) ratio based on the portfolio’s value, implied volatility, and borrower creditworthiness.
  • Some loan-stock agreements include conversion terms allowing the loan (or the lender’s claim) to convert into ordinary shares under predefined conditions and conversion rates.

Characteristics and types

  • Long-term debt-like instrument with fixed interest and scheduled payment periods.
  • Secured loan stock: backed by pledged shares; lender can seize collateral on default.
  • Unsecured loan stock: no specific collateral claim; lenders rank with other unsecured creditors in a default.
  • Convertible loan stock (including irredeemable convertible unsecured loan stock, ICULS): allows conversion into equity, providing an alternate recovery route for lenders.

Risks for lenders

  • Share-price volatility: collateral value can decline, leaving the loan under-collateralized.
  • Total loss: stock may fall to zero or the issuing company may become insolvent.
  • Market liquidity: thinly traded shares can be difficult to sell quickly at fair value.
  • Ownership consequences: if lenders take possession of large share blocks, they may assume voting rights and potential responsibilities as shareholders.

Impacts on issuing companies

  • If pledged shares are seized and sold, ownership can shift and influence corporate control.
  • Financial institutions that acquire meaningful shareholdings may gain voting power and affect corporate governance.

Businesses and market practice

  • Specialist lenders and broker-dealers provide portfolio-backed financing using securities as collateral.
  • Lenders evaluate portfolios, assign an LTV, and may adjust loan terms for volatility or concentration risk.

Role of the Primary Dealer Credit Facility (PDCF)

  • In financial crises, central banks may accept equities as collateral to provide liquidity. For example, the U.S. Federal Reserve’s PDCF expanded eligible collateral to include some equities during the 2008 crisis and again in 2020–2021.
  • Accepting equities exposes lenders (including central banks) to stock-market risk and raises the possibility that a lender could become a direct shareholder in borrower firms.

Related concept: stock lending

Stock lending is the temporary loan of shares to another party—commonly used to facilitate short sales, hedging, or arbitrage. The lender typically receives a fee and may receive collateral in return.

Key takeaways

  • Loan stock uses equity as collateral for financing; it combines features of debt and equity.
  • It reduces lender risk when secured but remains vulnerable to stock-price declines and liquidity issues.
  • Convertible structures alter risk/reward by offering potential equity participation for lenders.
  • During severe market stress, accepting stocks as collateral can create systemic exposures for lenders, including central banks.

Conclusion

Loan stock is a flexible financing tool that enables borrowers to leverage equity holdings for liquidity. It can be useful for portfolio-backed lending but requires careful assessment of market volatility, liquidity, and the potential governance implications if collateral becomes the lender’s property.