PIK, or payment in kind, bonds are a form of debt that allows the issuer to, at its own discretion, switch between paying cash and issuing more debt instead. Generally, PIK bonds carry hefty coupon rates, with the in kind bonds paying higher coupons still. PIK bonds have higher default rates than other, similar high-yield bonds.
Q. So these sorts of high yield bonds have been making a big comeback lately… what’s going on?
A. PIK stands for “payment in kind”. These became very popular in the LBO boom that preceded the last crash. As a reminder, these were “corporate fixer uppers” type deals– you buy a company for as little cash — and as much leverage– as possible, fix it up, and resell it; really, just like flipping a house. Often, the amount of leverage was really pushing the envelope of the company’s ability to repay it, so the idea was to build in additional flexibility for the company, and allow it to “pay in kind” instead of in cash.
Q. And so how do they work, exactly?
A. Well, when issued they pay very juicy yields in cash, these days maybe 10%. Seems very attractive. But they have a feature called a “toggle” — the issuer can, whenever it wishes, switch and issue more bonds in lieu of cash interest payments. Usually these “toggle notes” will carry a higher coupon than the original.
Q. We’ve seen a huge jump in the number of high yield bond issuances this year… Is this a big part of the trend?
A. Yes, there have been several in the last few weeks alone. They’re still used in LBO deals by PE firms, but sometimes you’re seeing them not in the buyout deal itself, but afterwards. That is, the issuer is already owned by private equity firm, and the proceeds from the issue are used to pay out dividends to the owners. Now, I don’t know about you, but that would make me nervous: that tactic suddenly switches some of the risk of future performance to the bondholders from the stockholders.
Q. So speaking of performance, what’s the history been?
A. Quite ugly. PIK bonds, not terribly surprisingly, have very substantially higher rates of default than normal bonds. And this isn’t just an issue for institutional investors; these things are finding their way into high yield bond funds that normal folks are buying like crazy these days. The hunt for yield is starting to drive a lot more risk taking across the board; I guess this is a natural result of the Fed’s ZIRP, but you do wonder if individuals indirectly owning PIK bonds was really part of the plan.