What are PIK Bonds?
PIK Bond stands for Payment in Kind Bond. The term ‘payment in kind bond’ partially speaks its definition. In any normal bond, interest is paid in cash. When the interest is paid in kind (i.e., not paid in cash), such bonds are called Payment in Kind (PIK) Bonds. In place of paying cash, additional bonds are issued to the investor. These bonds fall under the category of deferred coupon bonds.
From the definition, we can infer that these bonds are useful to issuers who are not sure of the availability of funds at the time of interest payments.
- What are PIK Bonds?
- Explanation with Example
- Advantages and Disadvantages of PIK Bonds for Investors
- Advantages and Disadvantages of PIK Bonds for Issuer
At times, the terms of the bond may also give issuers the flexibility of paying interest in cash, if funds are available to them. These bonds are also known as “PIK toggle” or “PIK toggle notes,” as they have a feature that allows the issuer to switch between cash interest payments and PIK interest payments at their discretion.
Explanation with Example
Company X issues PIK bonds worth $10,000 for a period of 5 years. Let us assume the interest rate to be 10% for the sake of simplicity. And, the company’s bond indenture mentions that it will pay 50% interest as cash and the rest 50% it will pay in kind. Look at the table below to understand how company X deals with this 50% pay-in-kind interest.
|Date||Opening Balance||Total Interest Due||Cash Interest||PIK Interest||Closing Balance||Payment|
The interest payment that the company made in the form of PIK gets capitalized. The issuer adds this amount to the principal amount and further interest calculation takes place with the compounding effect each year. This means that the principal amount of the bond grows over time, increasing the total amount that the issuer will need to pay when the bond will be redeemed.
Also, the point to note over here is that, according to the example above, the interest rate is fixed at 10%. But the company may issue these bonds at a floating rate of interest too. Another option with the bond issuer is to offer its bondholders a predetermined interest rate that may increase or decrease over time.
Advantages and Disadvantages of PIK Bonds for Investors
PIK bonds have some unique features compared to traditional bonds. Let’s look at the advantages and disadvantages of investing in PIK bonds from the perspective of investors:
Potentially Higher Yield
The first clearly visible advantage to PIK bond investors is its high yield compared to traditional bonds. This makes them attractive to investors seeking higher returns. These bonds offer higher yields to reward investors for bearing the additional risk.
Potential for Capital Appreciation
An investor of PIK bonds can have capital appreciation in 2 scenarios
- Decreasing Trend in Interest Rates – An investor invests in any security by looking at its risk and reward ratio. If such PIK bonds were issued at 10% and in a few years, if the market interest rates fall to 7%, the value of such bonds will increase. Investors would be ready to pay more for the bonds fetching interest rates higher than the market at that point in time.
- Significant Improvement in Issuer’s Financial Position – When a company sources capital at 10% and generates an ROI of 15% by utilizing this capital, the company improves its financial position in the long run. Once, the financial position, especially the cash flow position improves, the risk of paying the PIK bonds decreases significantly. We know there is a direct relationship between risk and reward. Now, the same PIK bondholders are able to earn the same returns with lower risk. This appreciates the value of the bonds in the market.
The basic theory of portfolio management says the portfolio should be well diversified to reduce the diversifiable (unsystematic) risk. PIK bonds have very different risk features compared to traditional bonds and may perform differently under different market conditions. Overall, the objective of diversifying a portfolio is well addressed with such bonds.
PIK bonds are generally considered riskier than traditional bonds due to their deferment in interest payment, and overall complex structure resulting in the potential for the issuer to default on interest or principal payments. Primarily, the higher yields offered by PIK bonds are the consequence of the higher risk involved.
Because interest payments can be made in kind, there may be uncertainty about the actual cash flow that will be generated by the bond over time. This makes it difficult for investors to plan their investment strategy and manage their risk.
PIK bonds are less liquid than traditional bonds. An investor can convert his investment into cash in two ways –
- Investment Matures – These bonds generally mature in 5 years or more.
- Sell in Open Market – Risk is high because of uncertainty, and uncertainty is due to complex structure, these things make it an uncommon or less prevalent option to explore, and that makes its liquidity limited.
The structure of PIK bonds is complex, requiring a higher level of expertise to analyze and value them properly. The complex structure of PIK bonds may also make it more difficult to accurately assess the true value of the bonds.
Overall, investing in PIK bonds can be a suitable option for investors seeking higher returns and diversification, but it is important to carefully consider the risks and rewards before investing. It is also important to have a good understanding of the specific terms and structure of the PIK bond before making an investment decision.
Advantages and Disadvantages of PIK Bonds for Issuer
Why should companies issue PIK Bonds? Issuers who invest in projects that have cash outflow now and cash inflow begin a few years later. An example of such projects could be growing trees which may require investing in land and other resources now and fruits grow and sold after a few years. In this situation, the unique features of PIK bonds can be an appropriate source of finance for the project. Let’s look at PIK Bond’s advantages and disadvantages from the perspective of an issuer:
Deferment of Interest Payment
PIK bonds are typically used by companies that have high levels of debt and limited or uncertain cash flow, as they can help reduce the immediate burden of interest payments while still allowing the company to access capital.
As we discussed about the Toggle PIK bonds wherein they get the flexibility to choose the mode of interest payment i.e. cash or additional issue of bonds.
Other benefits are as follows:
The tax benefit is an inherent benefit of debt for the companies in the form of a tax shield. Interest is a tax-deductible expense. For companies, which report profits, interest payments can significantly save on tax.
When a company is able to generate higher say 15% ROI against the cost of capital of 10%, the effect of financial leverage supercharges the return on equity for the shareholders of the company. This is how the issuer is able to achieve wealth maximization for their shareholders. This is beneficial only when the ROI is higher than the cost of capital. Please note that this is also not a specific benefit of PIK bonds but the bonds in general.
Higher Cost of Capital
Because PIK bonds are typically perceived as riskier by investors, the issuer is bound to offer a higher yield than traditional bonds. This increases the cost of capital significantly.
Very Bold Commitments
In such bonds, if the company has issued PIK bonds at fixed interest rates, it is bound by the commitment to pay say, 10% interest rates after 5 years even if the current market rate at that time is 7%. If the company smartly issues PIK bonds with flexible or floating rates of interest, the company will be in a winning situation in case of decreasing interest rate trends and vice-versa.
Huge Redemption Amount
The deferral of cash interest payments means that the principal balance of the bond will increase over time, as the interest payments are added to the principal instead of being paid out in cash. This results in a larger payment burden for the issuer at the time of redemption.
Hindrance to Additional Debt Funding
Debt burden increases with every passing year and the face of the balance sheet becomes highly levered. This impacts all the debt ratios of the issuer. Financial institutions may find the company overly leveraged and may avoid further funding for other projects.
Payment in kind bonds is a boon for companies facing a cash crunch. It is at the company’s discretion to pay the interest on this debt which makes this instrument favorable from the company’s point of view. And, 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. It’s important to note that these are generalizations, and specific characteristics of individual bonds may vary.
Refer to Terms and Conditions-SGL International A/S for an example of Subordinated Unsecured PIK Interest Rate Bonds.