Pricing Mechanisms

How Debt is Priced — Strata DSA

Why Pricing Exists

Debt pricing is compensation for risk. Every pricing concept maps to what a lender needs to be made whole for giving up capital today.

Pricing Foundations

Three Things Lenders Price For

Time Value of Money

Capital tied up over time has an opportunity cost. A lender forfeits alternative uses of that cash for the life of the loan.

Credit Risk

The borrower might not repay. The lender must be compensated for the probability and severity of default.

Optionality Risk

The borrower might repay early when rates fall, forcing the lender to redeploy capital at worse yields. Every pricing concept in this module maps to one of these three risks.

Fixed vs. Floating Rate

The rate structure determines how interest is calculated and which investors are natural buyers of the instrument.

Rate Structure

Fixed vs. Floating Rate

Fixed Rate

The interest rate is set at origination and does not change for the life of the instrument. The borrower knows exactly what they will pay. Example: a 7.5% coupon bond pays 7.5% on par value every year until maturity, regardless of market moves.

Floating Rate

The rate moves with a market benchmark, plus a fixed margin on top. Actual payments change as the benchmark moves. Example: SOFR + 400 bps, if SOFR is 5%, the borrower pays 9%; if SOFR drops to 3%, they pay 7%.

Rate Structure

Who Uses Which and Why

Fixed Rate - Bond Markets

Typical in high-yield and investment-grade bond markets. Investors such as pension funds and insurance companies want predictable cash flows they can match against long-dated liabilities. Certainty is the product.

Floating Rate - Leveraged Loans

Standard in leveraged loan markets (revolvers, TLAs, TLBs, unitranche). CLOs and credit funds prefer floating because it provides natural protection against rising rates. Their own funding costs are also variable, so a floating asset hedges their liability side.

The Base Rate & Credit Spreads

SOFR establishes the risk-free floor. The spread on top is where the lender's credit judgment is expressed as a number.

Base Rate

SOFR: The Benchmark Rate

SOFR (Secured Overnight Financing Rate) is the benchmark interest rate for dollar-denominated floating rate debt
Published daily by the New York Fed; it is the volume-weighted median rate in the U.S. overnight repo market
Term SOFR (1-month or 3-month) is used in practice, giving borrowers a known rate for each payment period rather than recalculating daily
SOFR = compensation for time. It represents the minimum return a lender requires simply for deploying capital, before any credit risk is considered
Spread = compensation for risk. Credit risk, liquidity, complexity, and market beta are all layered on top of SOFR

Mental model: SOFR answers "what does time cost?" The spread answers "what does this borrower's risk cost?" Together they give you the full pricing stack.

Credit Spreads

How a Spread Is Built

What the Spread Is

The additional premium above the risk-free rate that compensates for the risks of lending to a specific borrower. Expressed in basis points — 1 bps = 0.01%. SOFR + 400 bps means 4.0 percentage points above SOFR.

Layer 1 — The Market Spread

Every loan starts from a market baseline reflecting where comparable instruments are trading — informed by the loan type (TLB, unitranche, HY bond) and the borrower's industry. Lenders price healthcare credits differently than retail credits because the underlying cash flow risk profiles are systematically different. This layer is driven by market conditions and broad comparables, not anything specific to the borrower.

Layer 2 — Loan-Specific Adjustments

From the market baseline, lenders adjust up or down based on factors unique to the deal. Each factor carries its own premium or discount, applied with deliberate judgment.

Credit Spreads

Layer 2 — Loan-Specific Factors

Business Risk

The quality, stability, and predictability of the borrower's cash flows. A highly recurring, defensible business commands a tighter spread; a volatile or commoditized business pays more.

Structure & Seniority

Where the instrument sits in the capital stack. First lien secured prices tighter than second lien, which prices tighter than unsecured. The lender's recovery position in a downside scenario is directly reflected in the spread.

Leverage

How much debt the borrower already carries relative to cash flow. A borrower at 6x debt/EBITDA pays a wider spread than an identical business at 3x — less cushion before the lender's position is impaired.

Liquidity & Complexity

A bilateral private credit loan the lender may hold to maturity carries a higher liquidity premium than a broadly syndicated loan with an active secondary market. Bespoke instruments with tailored covenants and ongoing monitoring requirements also carry a complexity premium.

In practice: When a lender quotes SOFR + 500 on a middle-market unitranche, they started with a market reference, then adjusted for business risk, seniority, leverage, liquidity, and complexity — each a deliberate pricing decision.

Pricing Grids

Some loans have a spread that adjusts automatically as the borrower's leverage changes — aligning compensation with actual risk at all times.

Pricing Grids

Leverage-Linked Spread Table

Leverage Ratio	Spread
> 5.0x	SOFR + 425 bps
4.0x – 5.0x	SOFR + 375 bps
3.0x – 4.0x	SOFR + 325 bps
< 3.0x	SOFR + 275 bps

Key incentive: Pricing grids create a direct financial incentive for borrowers to pay down debt — deleveraging immediately reduces the spread, lowering cash interest expense. Common in investment-grade and TLA facilities; TLBs typically use fixed spreads to simplify secondary market valuation.

Original Issue Discount

OID is an upfront pricing lever embedded at issuance — it increases the lender's effective yield without changing the stated coupon.

OID

How OID Works

OID as a Yield Enhancer

Instead of receiving the full face value, the borrower receives less — say 99 cents on the dollar — but is still obligated to repay 100 cents. That 1-cent gap is the OID.

OID is most common in leveraged loans (TLBs), where it functions as a market-clearing mechanism. Typical OID is 98–99; in stressed markets it can reach 96–97.

Borrowers must evaluate OID separately from the spread — "SOFR + 500 at 99" is economically worse for the borrower than "SOFR + 500 at par."

Reading OID as a market signal: A loan clearing at par signals strong demand and a well-priced deal. A loan requiring 97–98 OID to clear signals the market found the spread insufficient — the borrower effectively paid a higher cost through the back door. Always ask: what did it clear at, and what does that tell you about how the market assessed the risk?

Call Premiums & Make-Whole

Lenders are compensated for optionality risk — the risk that a borrower repays early when rates fall, forcing redeployment at lower yields.

Call Protection

Call Premiums — Loans vs. Bonds

TLB

Soft Call on Term Loans

TLBs often include a soft call premium of 101 (1% of outstanding principal) if repaid within the first 6–12 months. After that, the loan is prepayable at par. This discourages immediate repricing after close without creating long-term lock-in.

Call Schedules on HY Bonds

High-yield bonds have more structured call protection because their fixed-rate nature creates greater reinvestment risk. A typical structure includes a non-call period of 3–5 years, followed by a declining call schedule — e.g., callable at 104 in year 4, 102 in year 5, par in year 6 onward.

Make-Whole Provisions

Allows early repayment but requires the borrower to pay the present value of all remaining future cash flows, discounted at a Treasury rate plus a small spread. Expensive by design — gives a legal mechanism for scenarios like M&A without creating routine refinancing risk for the lender.

Reading call structure as a practitioner: Heavy call protection — long non-call periods, steep premiums — signals a lender market where investors dictated terms. Minimal call protection signals a borrower-friendly market. Call structure is a useful proxy for prevailing market conditions at the time of issuance.

Total Cost of Debt

The true all-in cost stacks multiple pricing levers — each addressing a different form of lender compensation.

All-In Cost

Building Up the All-In Yield

Practical Example: TLB Pricing

SOFR + 475 bps, issued at 98 OID, 1% upfront fee, 4-year expected life.

Stated interest rate: 9.25% (SOFR 4.5% + 4.75%). OID of 2 points over 4 years adds ~0.50% per year. Upfront fee of 1% adds ~0.25% per year.

True all-in cost to borrower: ~10.0% — materially above the headline rate.

Practitioner habit: Always convert to all-in yield — it prevents being misled by a headline spread that looks attractive but obscures cost buried in fees and OID. On either side of the table, evaluating the full package is what separates sophisticated participants from those who get surprised.