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In this article we are going to review a number of different features regarding payment-in-kind bonds. Investors who purchase this type of security may receive a coupon rate that is paid in additional bonds, shares of preferred stock or a combination of cash and securities. Some issuers, especially those who may be experiencing cash-flow problems may elect to issue payment-in-kind bonds. Payment-in-kind bonds also known as PIK (pronounced pick) bonds, make coupon payments to the bondholders in the form of additional bonds rather than in cash. From the issuer’s perspective, the issuance of PIK bonds allows them to increase liquidity without taking on the obligation of making interest payments. In this way PIK bonds act like a type of zero coupon bond. However, the issuance of additional bonds as a form of coupon payment, increases the issuer’s outstanding debt obligation and increases the issuer’s leverage. The issuance of additional bonds acts as a type of negative amortization. This means that the total principal amount owed by the issuer increases as the years go by. PIK bonds contain a relatively high degree of risk. As a result, the coupon rate on the bonds is traditionally higher than interest-paying bonds. The following table illustrates how the issuance of additional securities impacts the issuer’s outstanding obligations.
$10,000,000 PIK bond paying a 10% coupon compounding semi annually
|Coupon Payment||Bonds issued||Total PIK Principal|
|Year 1 PIK Payment 1||$500,000||$10,500,000|
|Year 1 PIK Payment 2||$550,000||$11,050,000|
|Year 2 PIK Payment 1||$552,500||$11,602,500|
|Year 2 PIK Payment 2||$580,125||$12,182,625|
As the example above shows, the total outstanding debt has increased substantially in just two years. This increased debt load puts the issuer at increased risk of default. This example of a PIK bond details how the bonds received as payment in kind also receive coupon payments in additional bonds. The terms and conditions under which PIK bonds pay interest varies greatly from issue to issue and in some cases the bonds received as payment in kind may have different maturities, may or may not receive additional coupon payments Etc. In fact, some PIK bonds will pay interest in shares of preferred stock. Some PIK bonds will pay a portion of the stated coupon payment in cash and will make the rest of the coupon payment in additional bonds. A toggle PIK bond is one which will pay interest in cash at a stated rate or will pay interest in additional bonds at a higher rate. For example, if an issuer has a toggle PIK bond outstanding that bond may pay interest in cash at a rate of 8% or pay interest in additional bonds at a rate of 12%. Payment-in-kind bonds are only suitable for the most sophisticated investors such as hedge funds or other institutional investors with a substantial ability to understand and absorb the risk associated with payment-in-kind bonds. PIK bonds are never a suitable recommendation for an investor seeking income and are generally not suitable for individual investors.
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