A bond that pays interest in the form of additional bonds rather than in cash during the initial period is known as a payment-in-kind (PIK) bond. The issuer of the bond incurs additional debt by creating the new bonds for the interest payments.
Since there are no cash interest payments during the bond’s term so these payment-in-kind bonds are considered to be a kind of deferred coupon bond.
Since there is a risk of default by PIK bond issuers and also it tends to be higher, that is why they normally have higher yields.
The following are the main features of a PIK or Payment-in-Kind bonds:
- These loans are generally unsecured and are not supported by any kind of pledge of assets as collateral.
- It usually takes more than 5 years for the maturity of the payment-in-kind bonds.
- In this type of loan, the lender has the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time, or any kind of similar mechanism which helps the loaner to have a share in the prospective success of the business. Hence, it can be said that this loan comes with a detachable warrant.
- Refinancing of this kind of loan is generally restricted in the initial years and in case it is permitted it comes at a high premium.
The concept of a payment-in-kind bond can be better understood with an example. Let’s assume a company takes a mezzanine loan for $30 million with 5% in PIK interest and 16% in current cash interest, without warrants and with the due date of note in 5 years’ time.
After a year’s time the current interest of $4.8 million, as per the deal, is paid in cash while the PIK interest of $1,500,000, is paid in security and is accumulated to the principal amount of the note, raising that amount to $31.5 million.
This goes along to be compounded till the end of the fifth year when the loaner will receive the Payment in Kind interest in cash at the time when the note is paid at maturity.
Types of Payment In-Kind Bonds
The following are a few types of payment- in -kind bonds;
PIK Bonds Toggle or Pay If You Like
In this type, the borrowing companies have the option to defer the payment of interest by issuing additional bonds and are allowed to pay after the bond matures.
It is at the sole discretion of the companies whether they choose to pay the interest periodically or on maturity and in the form of cash or otherwise. However, it is important that the issuer has to communicate with the bondholder of this allotment at least 6 months before the payment date.
Also, it is to be noted that if it is chosen that interest payments are to be made after maturity, the rate will be much higher than the actual rate of interest.
Pay If You Can PIK Bond
Under this type of bond, the bond issuing company has to pay the interest amount in cash upon fulfilling some of the criteria for restricted payment and if not, then they can pay in kind which attracts a higher interest rate on maturity.
True PIK Bonds
Under this type of PIK bond, there is an obligation to pay interest in kind or at least a part of it. It is mandatory for the bond issuing company.
Holdco PIK Bonds
Here the interest can be paid in cash if there is a residual cash stream available.
Significance of Payment In-Kind Bonds
Due to the following reasons, most of the companies prefer to take these payment in-kind bonds.
- This debt instrument increases the borrowing capacity of a company. By taking these bonds, the company is allowed to leverage its capital structure without creating too much pressure on its cash flows.
- As compared to other debt instruments, Payment in Kind debt gives the borrower a greater deal of flexibility which further strengthens them to protect cash for other purposes like capital expenditures, acquisitions, inorganic growth or to hedge against the potential downturns in the business cycle.
Though PIK bonds can prove to be beneficial for the companies they can also become problematic as well because they can make the company overleveraged, add into the firm’s existing debt load, and increase its liquidity problems.
By issuing PIK bonds doesn’t facilitate the company in providing complete relief of its debt, it just pushes the obligation to a future date. If the company fails to solve its liquidity issues by that time, it may run into the risk of default.