DEFINITION of Toggle Note

A toggle note is a payment-in-kind (PIK) bond in which the issuer has the option to defer an interest payment by agreeing to pay an increased coupon in the future. With toggle notes, all deferred payments must be settled by the bond's maturity.

BREAKING DOWN Toggle Note

A traditional bond or note is a debt instrument issued by firms as a means of raising money to fulfill short-term debt obligations or finance long-term capital projects. To compensate investors for lending their funds to the issuer for a period of time, the issuer pays interest or coupons to the investors. The coupon payments are made periodically and serve as the rate of return for investing in these securities. When an issuer experiences cash flow difficulties, it could default on its interest payments, causing investors to lose future income and even their principal investment.

However, companies with temporary cash flow problems can include a toggle clause at the time of bond issuance to ensure that a skipped payment is not categorized as a default. A bond with this feature is referred to as a toggle note. A toggle note is a loan agreement that allows a borrower to pay higher interest in the future in return for deferring interest payments now. This way, toggle notes provide firms with a way to raise debt while staying afloat during times of strained cash flow, and without defaulting. When cash is at a minimum, the firm can use the toggle to defer an interest payment. In lieu of a payment in cash, this means the interest will, in effect, be paid for by incurring additional debt, often at a higher rate of interest. For example, if a company chooses to defer paying interest until the bond matures, its interest on the debt may be stated to increase from 7.8% to 9.1%.

With toggle notes, a company may choose to make interest payments either in cash or by payment-in-kind (PIK), such as by additional notes and bonds, and during the term of the loan, the borrower can alternate back and forth between the two forms of interest payments within certain parameters.

Toggle notes are used most commonly by private equity firms involved in leveraged buyouts. If the purchase price of the target company exceeds leverage levels up to which lenders are willing to provide a loan, or if there is no cash flow available to service a loan, a toggle note will be used to finance the acquisition.

While this seems like an attractive option for a firm, it does come at a cost. The increased interest rate provides ample incentive to not miss an interest payment as borrowers, in the end, could find they have even more debt than planned if the credit cycle turns. In effect, toggle notes are an expensive, high-risk financing instrument which could leave lenders with huge losses if the borrower is unable to pay back the loan. Therefore, lenders give investing preference to borrowers with strong growth potential.