PIK loan

A PIK (Payment In Kind) loan is a type of loan which typically does not provide for any cash flows from borrower to lender between the drawdown date and the maturity orrefinancing date, not even interest or parts thereof (see mezzanine loan), thus making it an expensive, high-risk financing instrument. PIK is to be interpreted as interest accruing until maturity or refinancing.

PIK loans are typically unsecured (i.e., not backed by a pledge of assets as collateral) and/or with a deeply subordinated security structure (e.g., third lien). Maturities usually exceed five years and in a standard offer, the loan carries a detachable warrant (the right to purchase a certain number of shares of stock or bonds at a given price for a certain period of time) or a similar mechanism to allow the lender to share in the future success of the business, making it a hybrid security.

PIK lenders, typically special funds, look for a certain minimum internal rate of return, which can come from three major sources: arrangement fee, PIK, and warrants. There are also minor sources, like a ticking fee. The arrangement fee, usually payable up-front, contributes the least return and is more aimed to cover administrative costs. PIK is interest accruing period after period, thus increasing the underlying principal (i.e., compound interest). The achieved selling price of the shares acquired under the warrant is also a part of the total return of the lender. Typically, refinancing of a PIK loan in the first years is either completely restricted or comes at a high premium (i.e. prepayment protection) to suit internal requirements of investing funds.

Interest on PIK loans is substantially higher than debt of higher priority, thus making the compound interest the dominating part of the repayable principal. In addition, PIK loans typically carry substantial refinancing risk, meaning that the cash flow of the borrower in the repayment period will usually not suffice to repay all monies owed if the company does not perform excellently. By that definition, PIK lenders prefer borrowers with strong growth potential. Because of the flexibility of the loan, also in the long term, there are basically no limits to structures and borrowers. Plus, in most jurisdictions the accruing interest is tax deductible, providing the borrower with a substantial tax shield.

With a PIK toggle note, the borrower in each interest period has the option to pay interest in cash or to PIK the interest payment. Sometimes, the borrower may also be able to PIK some portion of the interest (usually half) while paying the rest in cash; at times, only some of the interest may be paid in kind and the rest is cash-only. This feature allows the issuers to reduce cash interest payments for a period if necessary. The documentation often provides that if the PIK feature is activated, the interest rate is increased by 25, 50 or 75

Leveraged buy-outs

In leveraged buy-outs, a PIK loan is used if the purchase price of the target exceeds leverage levels up to which lenders are willing to provide a senior loan, a second lien loan, or a mezzanine loan, or if there is no cash flow available to service a loan (i. e. due to dividend or merger restrictions). It is typically provided to the acquisition vehicle, either another company or a special purpose entity (SPE), and not to the target itself.

PIK loans in leveraged buy-outs typically carry a substantially higher interest and fee burden than do senior loans, second lien loans, or mezzanine loans of the same transaction. With yield exceeding 20% per annum, the acquirer has to be very diligent in assessing whether the cost of taking out a PIK loan does not outbalance his internal rate of return of equity investment.

Before the credit crunch of Summer 2008, several leveraged buy-outs have seen some secured second-lien term bank loans coming with PIK or, more frequently, PIK toggle features, in order to support the firm's ability to cover cash interest during the initial period after the leveraged buy-outs. If the acquired company performs well, the PIK toggle feature allows the equity sponsor to avoid giving extraordinary returns to the PIK debt, which might happen if the debt were strictly PIK. The PIK toggle largely disappeared in the wake of the credit crunch, though in early 2013 there were signs of a tentative comeback.^[1] Toward mid-year PIK toggle loans returned in force as the high yield bond market in the U.S. and - relatively speaking - Europe shifted into high gear.

PIK bonds

In modern finance, when a bond pays in kind (PIK), it means that the interest on the bond is paid other than in cash. The most common form of this is for the principal owed to the bondholder to be increased by the amount of current interest. Other forms of PIK arrangements are also found, such as paying (transferring to) the bondholder an amount of stock (in the company issuing the bond or in another, typically related, company) with value equal to the current interest due.

Often such arrangements are referred to by the acronym PIK. Most bonds pay cash, not in kind, coupons.

PIK can be used as a verb (e.g. the bond "PIKed") or an adjective (e.g. that bond is "PIKable"). Where a previously PIKed amount is revoked (as is permissible in some agreements), this is known as "unPIKing".

Examples

Main article: Glazer ownership of Manchester United

One high profile use of PIKs involved the controversial takeover of Manchester United Football Club in England by Malcolm Glazer in 2005. Glazer used PIK loans, which were sold to hedge funds, to fund the takeover, much to the displeasure of many of the club’s supporters,^[3] because the burden of the debt was placed on the club itself, not the Glazers.

Non-investment grade vs investment grade

Non-investment grade ratings are those lower than BBB- (or its equivalent), while an investment grade rating (or corporate rating) is BBB- or higher.

A non-investment grade rating is important as it suggests a greater chance of an issuer’s default, wherein the company does not pay the coupon/interest due on a bond or the principal amount due at maturity in a timely manner.

Consequently, non-investment grade debt issuers must pay a higher interest rate – and in some cases they must make investor-friendly structural features to the bond agreement – to compensate for bondholder risk, and to attract the interest of institutional investors.

Background - Public v private

Some background is in order. The vast majority of loans are unambiguously private financing arrangements between issuers and lenders. Even for issuers with public equity or debt, and which file with the SEC, the credit agreement becomes public only when it is filed – months after closing, usually – as an exhibit to an annual report (10-K), a quarterly report (10-Q), a current report (8-K), or some other document (proxy statement, securities registration, etc.).

Beyond the credit agreement there is a raft of ongoing correspondence between issuers and lenders that is made under confidentiality agreements, including quarterly or monthly financial disclosures, covenant compliance information, amendment and waiver requests, and financial projections, as well as plans for acquisitions or dispositions. Much of this information may be material to the financial health of the issuer, and may be out of the public domain until the issuer formally issues a press release, or files an 8-K or some other document with the SEC.

What is a junk bond?

“Junk bond,” or “speculative-grade bond” simply are other names for a high yield bond. These terms helped give the asset class some negative connotation in its more formative years. The asset class has matured into a large, liquid marketplace, however, which now attracts a broad swath of investors and multitudes of issuers.

How big is the high yield bond market?

After growing rapidly over the past 10-15 years, high yield now comprises roughly 15% of the overall corporate (investment grade) bond market, which itself is estimated at roughly $9.8 trillion, trailing the U.S. Treasury market ($12.1 trillion outstanding) but larger than the municipal bond market ($3.7 trillion outstanding), according to first-half 2014 estimates by industry trade group Securities Industry and Financial Markets Association (SIFMA).

Market history

Corporate bonds have been around for centuries, but growth of the non-investment-grade market did not begin until the 1970s. At this time, the market was composed primarily of companies that had been downgraded for various reasons from investment-grade, becoming “fallen angels,” (you can read about those here)  and which continued to issue debt securities.

The first real boom in the market was in the 1980s, however, when leveraged buyouts and other mergers appropriated high-yield bonds as a financing mechanism. Probably the most famous example is the $31 billion LBO of RJR Nabisco by private equity sponsor Kohlberg Kravis & Roberts in 1989 (the financing was detailed in the best-selling book Barbarians at the Gate).

The financing backing the deal included five high-yield issues that raised $4 billion. While certainly there have been huge deals in market since that transaction, it’s still notable today as the 16th largest high-yield offering on record, according to LCD.

Since then, more companies have found acceptance with a growing pool of investors as the high-yield market developed. High-yield bonds still are used to finance merger and acquisition activity, including LBOs (you’ll note that most of the deals in the table above backing leveraged buyouts), and often back dividend payouts to private equity sponsors, and the market still supports funding capital-intensive projects, such as telecommunications build-out, casino development and energy exploration projects.

These days, though, the market also is a good deal of its own refinancing mechanism, with proceeds often paying off older bonds, bank loans and other debt.

The high-yield market matured through increasing new bond issuance, which reached a peak of $287 billion in 2010, and via additional fallen angels, most notably Ford Motor Company and General Motors in 2005. Indeed, with the automakers’ combined $80 billion of fallen angel corporate bonds downgraded into the asset class, high-yield ballooned to roughly $1 trillion in 2006. Just ten years earlier, the asset class was a humble $200 billion, according to SIFMA. And with the ongoing new issuance weighed against maturing bonds and other bond take-outs, the market has held around approximately $1 trillion, according to Bank of America Merrill Lynch.

Steady growth of the high-yield bond market saw only a few notable speed bumps. There was the savings & loan scandal in the 1980s, the correction after the “tech wreck” in 2001, and of course most recently the subprime mortgage meltdown, credit crunch and financial crisis of 2008. Issuance that year was just $69 billion, the lowest in seven years, according to LCD.

Fallen angels

The first high-yield companies were the “fallen angels,” or entities that used to carry higher ratings, before falling on hard times. These companies might find liquidity in the high-yield market and improve their balance sheets over time, for an eventual upgrade. Some fallen angels often hover around the high-grade/high-yield border, and frequently carry investment grade ratings by one agency and non-investment grade by another. These often are referred to as “crossover,” “split-rated,” or “five-B” bonds. Other issuers might never improve, and head further down the scale, toward deep distressed and potentially default and/or file for bankruptcy.

Start-ups

Frequently, high-yield issuers are start-up companies that need seed capital. They do not have an operational history or balance sheet strong enough to achieve investment grade ratings. Investors weigh heavily on the business plan and pro forma financial prospects to evaluate prospects with these scenarios. Telecommunications network builds and casino construction projects are examples.

Bankruptcy exit

Bankruptcy exit financing can be found in the high-yield market. Publisher of the National Enquirer American Media and auto-parts company Visteon are recent examples. Both were well received in market during the first half of 2011 and secured the exit financing despite past investor losses with the credits.

Insurance companies

Insurance companies invest their own capital and account for around 29% of the investment community. These accounts cover insurance and annuity products.

Pension funds

Pension funds account for roughly 28% of the high yield investor universe. They seek greater return on the retirement money entrusted to them than what’s being paid out to retirees. Pension funds are trustees for the retirement money and act under prudent investment rules, which vary state to state.

CDOs/Collateralized Debt Obligations

Collateralized Debt Obligations, or CDOs, once comprised as much as 16% of the market. These packaged debt instruments invest in a pool of securities for a lower risk of default. Thus, the pool of bonds, or basket of securities, receives higher credit ratings. There are bond-only instruments known as CBOs, loan-only instruments known as CLOs and packages of both, which are generically described as CDOs. This segment of the investor base grew rapidly in the first half of the 2000 decade, only to wither in the credit crisis. As of 2012, it is unclear how much of the high-yield market is held in CDOs.

ETFs/Exchange-Traded Funds

Exchange-Traded Funds, or ETFs, have a miniscule-yet growing-presence in the high-yield market.

Recent additions to relatively plain-vanilla, broad-indexed ETFs (HYG, JNK,  and PHB) include actively managed (not indexed) fund HYLD, short-tenor funds (SJNK, HYS), international funds (IHYG and IJNK), non-U.S. high-yield (HYXU), and even a contrarian, short-seller fund (appropriately, SJB, suggestive of a mandate to “short junk bonds”).

Other specialty investors

The balance of the high-yield investment community comprises hedge funds and other specialized investors, both domestically and internationally, as well as individual investors, commercial banks, and savings institutions. Hedge funds had a growing presence in the high-yield market over the 2003-05 bull market and remain entrenched.

Secondary markets

Once bond terms are finalized and accounts receive allocations from the underwriters, the issue becomes available for trading in the aftermarket.

Secondary trading of high-yield bonds is a well-established and active marketplace. Broker-dealers often traffic in the “grey market” before the paper is “freed to trade,” and in some cases there are grey market indications even before terms of the offering are finalized. For example, a trader could indicate buying interest at issue price plus, or minus, valuation, such as a market quote “IP+1/4” or “IP-3/8.”

A move toward more transparent pricing comes on the heels of the full implementation of Trade Reporting and Compliance Engine (TRACE), the Financial Industry Regulatory Authority’s (FINRA’s) bond trade reporting system. Broker-dealers now report all trades of corporate bonds, including all registered high-yield issues, mostly within five minutes of execution, although the mandatory deadline stated is 15 minutes.

FINRA was formed by a consolidation of the enforcement arm of the New York Stock Exchange, NYSE Regulation, and the National Association of Securities Dealers (NASD). The merger was approved by the United States Securities and Exchange Commission (SEC) on July 26, 2007. It is a private corporation that acts as a self-regulatory organization (SRO). Though sometimes mistaken for a government agency, it is a non-governmental organization that performs financial regulation of member brokerage firms and exchange markets, according to Wikipedia citations.

The high-yield trading published by TRACE has its roots in a NASD system, the Fixed Income Pricing System, which provided hourly dissemination of prices and trading volumes of 50 liquid high-yield credits, and was known as the “FIPS 50.”

With trade reporting widespread, companies such as MarketAxess Holdings and TradeWeb Markets, owned by Thomson Financial, in turn provide almost real-time high-yield bond prices on their platforms.

Most bond traders have opposed increased market transparency, which erodes margins as bonds change hands. Investors generally say they want to trade the paper only at the levels where the most recent executions took place.

Regulators have long since said increased investor knowledge through a tool such as TRACE can only be a positive, arguing that retail investors should have as much information as institutional investors. As then SEC-chairman Arthur Levitt once famously delivered in New York in 1998, “The sad truth is that investors in the corporate bond market do not enjoy the same access to information as a car buyer or a homebuyer or, dare I say, a fruit buyer. And that’s unacceptable. Guesswork can never be a substitute for readily available price data.”

Underwritten deal

These transactions are marketed on a “best-efforts” basis. The financial institution underwriting the deal has no legal obligation to the issuer regarding completion of the transaction. This is the most common placement method. Issuers range across all industries. First-time issuers without a proven cash flow record are especially common in underwritten transactions.

Bought deal

A bought deal  is fully purchased by the underwriter at an undisclosed rate before marketing, and therefore is subject to market risk. This method removes execution risk to issuing companies, which are most commonly well-known and seasoned issuers. Timing is typically a day or less, which helps remove some market risk. Underwriters use this method to compete among themselves for business, but if they are too aggressive, and are unable to fully subscribe the deal, they are forced to absorb the difference, which they may later try to sell in the aftermarket. This is easy, of course, if market conditions – or the credit’s fundamentals – improve. If not, underwriters might have to take a loss on the paper or hold more than intended.

Coupon

Coupons, or interest rate, typically are fixed for the term of debt issue and pay twice annually. The average coupon for non-investment grade companies have been in the low 8% area in recent years, but double digits are by no means an exception.

Zero-coupon bonds

Some high yield bond issues pay no coupon at all. These deals are often called “zero-coupon bonds,” “zeros,” or “zips,” and are sold at a steep discount to face value by companies that might not have the cash flow to pay interest for a number of years. Here, investor return comes in the form of capital appreciation, rather than from interest payments.

Zeros were popular with Internet start-ups and wireless build-out projects in the late 1990s. In 1998 for example, zero-coupon issuance was $16 billion, or roughly 12% of total supply. in 2011, in contrast, there were just three such deals in market, raising $1 billion, or just 0.4% of total supply, and none since, according to LCD.

Floating rate notes

Certain deals are more attractive with a floating-rate coupon. These deals, referred to as “floaters” or “FRNs” most often pay interest quarterly, and at a spread priced to the LIBOR rate.

This type of coupon is popular amid an environment of rising interest rates, such as 2004 and 2005. During these years, floating rate issuance increased to 8% and 12% of all new issuance, from merely 1% of supply in 2003. In contrast, during the low-interest-rate environment of 2010-11, there were just essentially no such issuance, at just three individual deals, as LIBOR wallowed in a 0.25-0.5% context, according to LCD.