What are Payment-In-Kind Bonds
A payment-in-kind (PIK) bond is a type of bond that pays interest in additional bonds rather than in cash. The bond issuer incurs additional debt to create the new bonds for the interest payments. Payment-in-kind bonds are considered a type of deferred coupon bond since there are no cash interest payments during the bond's term.
BREAKING DOWN Payment-In-Kind Bonds
Some bonds are issued with interest rates, which are called coupon rates in fixed income terminology. Investors receive coupon payments semi-annually which are a form of return on investment (ROI) for the bond investor. For example, a bondholder who purchased a bond with $1,000 face value and 4% coupon to be paid semi-annually, will receive ½ x 4% x $1,000 = $20 in interest income twice a year. The lower the credit rating on the issuing entity, the higher the yield investors can expect on the bond.
Investors that purchase low-grade bonds are faced with the risk of the issuer defaulting on its payments. An issuer that runs into liquidity problems has the option of delivering more bonds in the form of additional principal to the bondholder for an initial period of time. Sometimes the investor has the option of receiving his or her coupon payments in cash or kind. Coupon payment received in the form of additional bonds is referred to as a payment-in-kind bond.
A payment-in-kind bond is a form of mezzanine debt that lessens the financial burden of making cash coupon payments to investors. No cash interest payment is made until the bond is redeemed or the total principal is repaid at maturity. On the dates when the coupon payments are due, the accrued interest on PIK debt is paid through the additional issuance of bonds, notes, or preferred stock. The securities used to settle the interest are generally identical to the underlying securities, but on many occasions, they have different terms.
For example, let’s assume a company issues a corporate bond with principal amount of $10 million due to mature in 7 years. The terms of the bond include a 9% cash coupon payment and 6% PIK interest to be paid annually. In year 1, the bondholders will receive cash payment for 9% x $10 million = $900,000, and 6% x $10 million = $600,000 is paid in additional bonds, increasing the principal amount of the issue to $10 million + $600,000 = $10.6 million. This continues to be compounded till the end of the seventh year, at which point, the lender will receive the payment-in-kind interest in cash when the bond is paid at maturity.
From the example above, PIK bonds result in more debt that needs to be repaid by the issuer. The principal amount to be repaid increases every year, which puts the issuer at risk of liquidity. The increased financial leverage taken on by the issuing company also increases its risk of default.
PIK bonds typically have maturity dates of more than 5 years and are unsecured, meaning that they are not backed by any kind of assets as collateral. The types of companies that issue PIK bonds may be financially distressed and their bonds may have low ratings but pay interest at a higher rate. Because payment-in-kind bonds are an unusual and high-risk product, they appeal mainly to sophisticated investors such as hedge funds. Investors seeking cash flow should not purchase payment-in-kind bonds.