Payment-In-Kind (PIK) Bonds

What Is a Payment-In-Kind (PIK) Bond?

A payment-in-kind (PIK) bond alludes to a type of bond that pays interest in extra bonds as opposed to in cash during the initial period. The bond issuer incurs extra debt to make the new bonds for the interest payments. Payment-in-kind bonds are viewed as a type of deferred coupon bond since there are no cash interest payments during the bond's term.

The risk of default by PIK bond issuers will in general be higher, which is the reason they typically have higher yields. The majority of investors who park their money in PIK bonds are institutional investors.

Understanding Payment-In-Kind (PIK) Bonds

Payment-in-kind is utilized as an alternative approach to paying cash for a decent or service. With a payment-in-kind bond, no cash interest payment is made to the bondholder until the bond is reclaimed or the total principal is repaid at maturity. It is a form of mezzanine debt that decreases the financial burden of making cash coupon payments to investors. On the dates when the coupon payments are due, the bond issuer pays the accrued interest on the PIK debt by issuing extra bonds, notes, or preferred stock. The securities used to settle the interest are generally indistinguishable from the underlying securities, however on many events, they might have various terms. Since there is no standard income, investors seeking cash flow or customary income shouldn't purchase payment-in-kind bonds.

PIK bonds regularly have maturity dates five years or more and are unsecured, meaning they are not backed by assets as collateral. Companies that issue PIK bonds might be financially distressed and their bonds might have low ratings, however they ordinarily pay interest at a higher rate. Since PIK bonds are an unusual and high-risk product, they mainly appeal to sophisticated investors, for example, hedge funds.

Payment-in-kind bonds generally mature within five years or more and are unsecured.

These kinds of bonds were generally famous when private equity started to boom in the ahead of schedule to mid-2000s. They started to lose their shine when the global financial crisis hit.

PIK versus Ordinary Bonds

A few bonds are issued with interest rates, which, in fixed income terminology, are called coupon rates. Investors receive coupon payments semi-yearly which are a form of return on investment (ROI) for the bond investor. So a bondholder who purchases a bond with $1,000 face value and 4% coupon that pays semi-every year will receive $20 (\u00bd x 4% x $1,000) in interest income two times per year. The lower the credit rating on the issuing entity, the higher the yield investors can anticipate on the bond.

Investors who purchase low-grade bonds are faced with the risk of the issuer defaulting on the payments. An issuer who runs into liquidity problems has the option of delivering more bonds in the form of extra principal to the bondholder for an initial period of time. This gives the bond issuer some breathing room from being required to make interest payments to bondholders. At times the investor has the option of receiving their coupon payments in cash or kind. Coupon payments received in the form of extra bonds are alluded to as payment-in-kind bonds.

Benefits and Disadvantages of PIK Bonds

Issuing PIK bonds is an option for some companies that experience cash flow or liquidity problems. Thusly, bond issuers can swear off having to make cash payments on the coupons to bondholders. They might find a few relief in the more immediate term and free up some cash for other, more vital areas.

While it might appear to be a boon, issuing PIK bonds can be a problem. That is on the grounds that it makes the company overleveraged, adding to the firm's existing debt load and its liquidity problems. Issuing PIK bonds doesn't lighten the firm of its debt, it just pushes the obligation to a future debt. In the event that it hasn't tackled its liquidity problems by that point, it might run into the risk of default.

Illustration of a PIK Bond

PIK bonds bring about more debt that should be repaid by the issuer. The principal amount to be repaid increases consistently, putting the issuer at risk of liquidity. The increase in financial leverage taken on by the issuing company likewise increases its risk of default.

We should expect a company issues a corporate bond with a principal amount of $10 million due to mature in seven years. The terms of the bond include a 9% cash coupon payment and 6% PIK interest to be paid every year. In the primary year, bondholders will receive a cash payment of $900,000 (9% x $10 million), while $600,000 (6% x $10 million) is paid in extra bonds. This increases the principal amount of the issue to $10.6 million ($10 million + $600,000). This continues to be compounded for the rest of the seventh year. As of now, the lender will receive the payment-in-kind interest in cash when the bond is paid at maturity.

Features

• PIK bonds are typically issued by financially distressed companies.
• These bonds might have low ratings and ordinarily pay interest at a higher rate.
• A payment-in-kind bond pays interest in extra bonds as opposed to in cash during the initial period.
• Despite the fact that they might give some financial relief, PIK bonds add to liquidity problems as the debt must be paid off sooner or later.