Payment-in-kind notes: Nit-piking

There’s nothing like a crisis to spawn financial exotica. Investors want yield and issuers — variously — want either a get-out-of-jail card, the wherewithal to swoop on discounted assets, or to fund future dividends.

Payment-in-kind notes and their PIK-toggle cousins fit the bill. There is no annual coupon payment; instead, interest payments are rolled up and added at the end, effectively enabling issuers to push out debt by financing it with more debt. At one end of the spectrum, PIKs carry more risk than equity and, given the potential for implosion that their straitened circumstances imply, potentially lower returns than plain vanilla bonds. The toggle version allows users to switch between paying coupons in cash and in kind.

Not for nothing have PIKs’ various resurgences coincided with ultra-low interest rates and typically presaged periods of financial mayhem: in 2005, as part of the buyout boom that helped inflate the credit bubble, and at present during the pandemic. The Glazer family used PIKs as part of their funding for Manchester United Football Club while ball bearing-maker Schaeffler’s parent used the instrument to refinance its subsidiary’s borrowings a decade later. Jammier still, private equity owners have been using PIKs to fund their own payouts on portfolios. 

The boom years were 2007-08 and 2013, when issuance hit $38bn and $29bn respectively, according to S&P. The tally year to date exceeds $18bn.

This looks like a high water mark. Investor appetites are being tested: witness the nixing of Platinum Equity-owned Multi-Color Corporation’s (a label maker) $500m note in late October. Market uncertainty wrought by fresh national lockdowns in Europe and a new government administration in the US could well further quell appetites.

More than that, patience is stretched by private equity’s use of proceeds. Debt to back dividends is not a compelling case at the best of times; far less so when you are not on the receiving end of the bounty. Much of the 2013 issuance was used for this purpose; this year has trod a similar theme. Issuers can just be thankful investors’ memories tend towards the very short: chances are PIKs will stage another resurgence.

This Lex is one of five on the theme of dominant financial concepts which defined 2020. The others can be found below.

Covid/corporate resilience: bent not broken

Stranded assets: oil be off

Tech stocks/SoftBank: prince of whales

Defensive all-share mergers: desperate measures