Is it PIK-up time for cash-strapped companies?

One of the things Austrian economists love about higher interest rates is that they are supposed to make the tide go out, revealing other (lesser) folk all swimming naked. The failure of higher rates to pop bubbles (when stocks someone doesn’t own rise a lot in value) is a source of continual annoyance.

So a new report from S&P Global Ratings on payment-in-kind bonds – aka PIKs – is going to really irritate them. Reading between the lines, S&P are forecasting a big increase in PIK issuance among lower-rated firms that are increasingly out of other options in a higher-yield world.

Let’s address the basics. PIKs have been with us since the 1980s. But if your career was forged in the era of ZIRP, or you’re just not that into bonds (😱), you can be forgiven for a lack of familiarity.

Regular corporate bonds promise the holder timely payment of coupons and principal, aka cash. PIKs? No such luck.

Rather than offering cash, PIKs promise the holder more and more debt until finally they need to be repaid in cash at maturity. 

Purists might object to this description: if things were quite so simple, a PIK would be the same as a zero-coupon bond. And yes, they’d be right. A PIK note tends to give the issuer options. Typically, these are to either a) pay cash coupons; b) toggle to ‘pay’ bondholders with more debt claims, albeit with some additional penalty (even more debt claims); c) to PIK for a while then switch to cash-pay; d) something else.

PIKs have always been at the risky end of the high yield spectrum, and MainFT has tended to strike a cautious tone around pretty much any firm that issues them, quoting one banker calling them a “Hail Mary���. Why would bondholders buy such things? The yield.

Anyway, back to the S&P report. They reckon that debt maturities of firms rated single-B or lower will be around $310bn in 2025, rising to $400bn in 2026. Surely in our no-landing global economic environment there’s plenty of free operating cash flow to go round, right?

Gulp.

Over to S&P:

To address these upcoming maturities, we expect these issuers will look to conserve cash and refinance through structures that permit them to pay interest with more debt instead of cash, known as PIK interest. … We expect these transactions will continue in 2024 and 2025 as debt maturities approach, credit conditions remain tight, and financial sponsors aim to bridge liquidity shortfalls and fund business turnarounds.

The note goes on to profile 25 PIK refinancings that occurred in 2023, mostly out of Default or Selective Default and into CCC-rated territory. Sure, a CCC-rated PIK bond looks better than a defaulted bond in your portfolio. But, as S&P puts it when explaining why U.S.-based Carvana Co. remained in the ‘CCC’ category despite a two-year debt maturity extension and 11 per cent debt reduction:

We believe the company’s liquidity improvement is only temporary, and its liquidity will come under pressure once its PIK debt converts to cash interest in two years. We do not forecast the company will generate sufficient EBITDA to cover its substantial cash interest payments.

🔥 🔥 🔥

While we can understand credit managers finding themselves making the best of a bad situation in a distressed exchange refinancing, buying these things off-the-shelf is not for the faint-hearted.

PIKs are the “fake it ‘til you make it” can-kicking instrument of the bond world. If S&P are right, Austrians will be seething that once again their day of reckoning is being postponed, if only temporarily.