Payment in Kind Bond is a financial debt instrument issued by the company to acquire funds from the investors.
A company has different types of structures for its capital to suit its debt-equity levels at different points during the business cycles. For acquiring finance, a company has to plan how to pay interest on the same. Payment in kind (PIK) bonds is one such debt structure in which a company pays interest to the lenders/investors by issuing extra bonds. The extra issue can be a mix of both cash and other debt instruments. Issued in place of cash interest payments, it is also regarded as deferred coupon bonds.
- What is a Payment-In-Kind Bond?
- Features of Payment in Kind Bonds
- Types of Payment in Kind Bonds
- Why Should One Accept Payment in Kind Bonds?
- Risks of Payment in Kind Bonds
What is a Payment-In-Kind Bond?
In a payment-in-kind bond, the borrowing company has to pay interest in the form of further bonds or preferred stocks. The concept behind this debt structure relies on the fact that the interest capitalizes over time. Then the accrued interest is paid in the form of other debt instruments on which the investor can earn money in the form of interest or dividends. The interest on payment in kind bonds is referred to as the coupon rate, which is a terminology of fixed income. The investors are paid coupon payments half-yearly as a return on investment.
Example: An investor invested INR 10,000 on payment in kind bonds by buying 10 such bonds of face value INR 1000, which pays 5% interest. Then his return on investment would be
= ½ x 5% x INR 1000 x 10
= INR 250, to be paid twice a year. So, his yearly ROI would be INR 500.
Features of Payment in Kind Bonds
The characteristics of payment in kind bonds are as follows –
These bonds come with a maturity period of more than five years. It depends on the company for how long they want to issue the bond.
These bonds are an unsecured form of debt due to a lack of an underlying asset. There is no collateral or mortgage attached to these bonds.
There cannot be any form of refinancing done on this debt in the first few years. Even if it is allowed, the cost for the same is too high.
There is a detachable warrant issued with these bonds, which provides certain rights to the investors to have a share of the profit of the business. With the warrant, the investor can purchase equity shares/bonds of the company, which will give the investor a share of the profit.
Types of Payment in Kind Bonds
There are different types of payment-in-kind bonds discussed below –
Payment in kind bonds toggle or pay if you like
In this type of PIK bond, the borrowing company can defer the payment of interest by issuing additional bonds. It can finally pay after the bond matures. It is the discretion of the company whether to pay the interest periodically or on maturity in the form of cash or otherwise. The issuer has to inform the bondholder of this allotment at least 6 months before the payment date. For interest payment is made after maturity, the rate is much higher than the actual rate of interest.
Pay if you can
Here the bond issuing company has to pay the interest amount in cash if some of the criteria for restricted payment are fulfilled. If not, then they can pay in kind, which attracts a higher interest rate on final maturity.
True payment in kind bonds
This is a plain vanilla payment in kind bond which has an obligation to pay interest in kind – at least a part of it. It is a compulsion for the company to issue bonds.
Holdco PIK bonds
It is a subordinated type of bond on which interest can be paid in cash if a residual cash stream is available.
Why Should One Accept Payment in Kind Bonds?
The investors of payment in kind bonds have the certainty to get their return on their investment. These bonds will pay the interest accrued on them – periodically or after maturity. Cash interests are not certain all the time, and thus PIK is a good way to fix your return on investment. People, who invest in private equities, often prefer these bonds as they want to preserve their return on investment. These bonds provide another debt instrument as interest is regarded as an addition to an investor’s profile without any further investment. This increases the overall return of the investor over a span of time. An investor would be most keen on such an arrangement if the growth trajectory of the company is high.
Also, see what other kinds of bonds offer and their features.
Risks of Payment in Kind Bonds
The payment in kind bonds comes with additional credit risk. It is because the lender has to forego the cash interest at that point in time. Credit risk uncertainty remains in the business environment for which the borrower compensates the lender with a higher and more profitable interest rate. Moreover, there is no underlying security/collateral safeguarding the interest of the investor. The bondholders get paid before the shareholders when the company liquidates.
Thus, payment in kind bonds is a boon for a well-established company in a cash crunch. One which is unable to pay interest in cash right away. It is at their discretion to pay the interest on this debt which makes this instrument favorable from the company’s point of view. Even with such high risks, the demand for the bond remains high due to the high-interest payment and return on investment from the investor’s point of view.