(Claudia Horsham, Michael Best, Xie Shi Jie David)
Current climate of the bond market
Since the Covid crisis began firms and consumers have been cutting back on spending which has led to many companies experiencing cash flow or liquidity problems. Government restrictions in many states, as well as an increase in employees working at home has resulted in unexpected costs and falling profitability for firms. The uncertainty surrounding the development of a vaccine and the outcome of the US presidential election has made it increasingly difficult for firms to plan for the future and has resulted in many companies rushing to secure debt with companies raising record amounts of debt in the US bond market with total US corporate bond issuance reaching $1.919 trillion. Similarly, low interest rates around the world and monetary stimulus has decreased yields of the highest-quality bonds with the ‘real’ yield on some bonds turning negative. Support by the Federal Reserve for the corporate bond market by pledging to purchase company debt for the first time, has increased bond prices leading to falling yields (since there is an inverse relationship between the price of bonds and the yield) with some investors willing to accept a loss in real terms. As a result, this has led to a resurgence of Payment-in-Kind (PIK) bonds with some investors willing to seek out higher returns in assets which carry greater risk and are of lower-quality.
What is a Payment-in-Kind (PIK) bond?
A payment-in-kind (PIK) bond refers to a type of bond that pays interest in additional bonds rather than in cash during the initial period. The bond issuer incurs additional debt to create the new bonds for the interest payments. By adding the interest to the principal of the bond, the debt’s interest is de facto payed with more debt which allows a company to defer interest payments until the bond matures. PIK bonds typically have maturity dates five years or more and are unsecured since these bonds are not backed by any assets or other forms of collateral, that investors would claim in lieu of the debt, if the amount owed on the date of the bond’s maturity is unable to be paid. It is a type of deferred coupon bond since there are no cash interest payments during the bond’s term. Thus, the risk of default by PIK bond issuers tends to be higher, which is why the yield on PIK bonds tends to be much higher. Hence, more often than not, it is institutional investors (for example, owners of hedge funds), that park their capital in PIK bonds, then corporate bond investors.
Payment-in-Kind (PIK) bonds are a form of mezzanine debt that lessens the burden on struggling corporations on paying cash coupon payments to investors. On the date of the bond’s maturity, the issuer of the PIK bond pays the total amount of interest accrued on the bond by issuing further bonds, notes, or preferred stock. Thus, there is no regular income flow to investors hence why it is institutional investors that tend to purchase these high risk PIK bonds.
Companies that tend to issue these high-risk-high-yield bonds are often financially troubled with high amounts of corporate debt and are making considerable losses and are associated with issuers who are already struggling to pay interest on debt they already owe. Corporate bonds issued tend to have low ratings and may even be considered as junk hence why they tend to pay a higher yield. Similarly, the debt issued through these Payment-In-Kind bonds sits lower down the company’s capital structure, putting it at greater risk of the debt being crossed off if the company goes bankrupt hence, holders of PIK bonds do not ever receive the bonds coupon payments.
Why have PIK bonds re-emerged of late?
With 10 Years Treasury Yields dropping to a record low level of 0.83% as shown in the chart below from Moody’s of the yield on a 10-year treasury note. The yield on investment grade bonds has also dropped close to 2%. Thus, fixed income investors are now willing to take on higher levels of risks from other forms of bonds such as PIK bonds. Portfolio managers are also seeking higher yield investments due to expectations of a low interest rate environment for the next two years as the global economy struggles to get back on its feet.
(Source:Moody’s 10 Year Treasury Rate)
(Source: Moody’s Seasoned Aaa Corporate Bond Yield)
What companies of private equity firms are taking up PIK notes?
At a time where companies are rushing to secure capital and interest rates on government debt and on savings having tumbled to historic lows, private Equity firms are hitting the market knowing that investors are willing to buy almost any junk bonds and risky deals where they can grasp a higher return on their investments.
Apollo Global Management owned by Aspen Insurance sold $500 Million in PIK toggle notes, with 50% of the capital set aside for dividend payments. The five-year deal is priced with an interest rate of 7.63% which could rise to above 8.38% if interest payments are deferred further, or possibly even double digits if Apollo chooses to pay interest on the date the bond matures.
Husky, which is a packaging company backed by Platinum sold $460 million at the start of this year but recently, the price of debt has fallen to below seventy cents on the dollar. This is signalling to traders the company has a high probability of being unable to repay the debt since the price of debt has tumbled to a record low. Unsurprisingly Platinum Equities owned label maker Multi-Colour Corporations was also looking to raise $500 million with a five-year PIK note until the deal was called off. This is not the first time Platinum has raised capital through PIK bonds. In 2013, Chassix, a car chassis manufacturer, raised $150 Million in PIK notes to finance a payout. Chassix slipped into bankruptcy two years later. Will we see a similar result in 2020?
Upon the closing of the US election, we may see a decrease in intervention from the Federal Reserve and the US government if volatility subsides. If this is not the case, companies which are struggling due to the pandemic may have to resort to PIK bonds to remain solvent. Moreover, the question remains as to how worthy are these PIK bonds and are investors besides that of the institutional investor willing to invest their assets at such high risk? Is the re-emergence of PIK bonds temporary, or are PIK bonds here to stay? So long as the economy manages to get back on its feet, yields of safer corporate and government debt should rise and it is most likely investors will purchase these safe assets where the spread in the yield is small and, once again, Payment-in-Kind (PIK) bonds will disappear – for now anyway.
Payment-in-Kind (PIK) bond – A type of bond that pays interest in additional bonds rather than in cash during the initial period.
Leverage – An investment strategy of using borrowed money to increase the potential return of an investment. Leverage can also refer to the amount of debt a firm uses to finance assets.
Corporate bond – A type of debt security that is issued by a firm and sold to investors.
Yield – The earnings generated and realized on an investment over a particular period of time.
Hedge fund – Financial partnerships that use pooled funds and employ different strategies to earn active returns for their investors.
Coupon – Also known as a coupon payment is the annual interest rate paid on a bond.
Corporate debt – An amount of money borrowed and owned by companies
Private equity – An alternative form of private financing, away from public markets, in which funds and investors directly invest in companies or engage in buyouts of such companies.
Maturity – The agreed-upon date in which an investment ends.
Bankruptcy – Legal proceeding carried out to allow individuals or businesses freedom from their debts, while simultaneously providing creditors an opportunity for repayment.
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