Payment in Kind Bonds (PIK): What Are They and How PIK Works?

Payment-in-kind or PIK bonds are a special type of bond that does not make coupon payments in cash. PIK bonds make deferred coupon payments or make them in the form of bonds, preferred stocks, or notes.

These bonds are commonly issued by companies in financial distress. These are unsecured loans and offer higher coupon payments to investors. PIK bond issuers can raise capital and utilize the cash for business needs rather than making coupon payments. However, the strategy is very risky and needs to be executed carefully.

What is a Payment-in-Kind Bond?

A Payment-in-kind bond is a type of bond that makes coupon payments in the form of bonds or any other security. It does not pay coupons in the form of cash.

The PIK bonds either do not make any cash payments or make cash payments in conjunction with in-kind assets. For instance, in the early years of a PIK, the investors may receive coupon payments partly in cash and the remaining in kind.

These bonds work similarly to mezzanine debt. The term PIK can also be associated with other debt instruments. These bonds are unsecured and come without any collateral. These bonds offer great flexibility to issuers but pose some risks as well.

How Does a Payment-in-Kind Bond Work?

PIK bonds are sometimes referred to as a special type of deferred coupon bond. PIK bonds also defer the coupon payments until maturity.

These bonds do not come with collateral; hence they are considered an unsecured form of debt. However, financially distressed companies can issue these bonds to raise capital and save cash by making coupon payments in the form of an underlying asset rather than cash.

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Most of these bonds typically do not make any coupon payments until the bond is redeemed or comes to maturity. In some cases, the issuer makes coupon payments in the form of issuing new bonds, preferred stocks, or notes. The asset used for payment-in-kind can be any asset, however, it is usually issued in the form of new bonds.

PIK bonds come with the following features.

  • These bonds come with a maturity of five years or less commonly.
  • These bonds are a form of unsecured debt meaning there are assets pledged as collateral.
  • PIK bonds come as a hybrid security. They come with warrants attached that can be converted to preferred stocks or bonds within a specified period.
  • These bonds come with refinancing restrictions for a certain period from lenders.

Special Considerations with PIK Bonds

PIK bonds are unsecured loans; hence investors demand higher interest rates. Also, PIK bonds are typically issued by companies in financial distress. It means the lower credit rating of the company would make the interest rates further higher. At the same time, issuers can use PIK bonds to save cash reserves.

Bond issuers can also take different routes in the payment-in-kind approach.

Some common forms of PIK approaches include:

  • True payment-in-kind
  • Pay if you can
  • Holdco PIKs
  • PIK toggles

PIK bonds come with warrants attached. It means the issuers have the option of issuing new bonds or preferred stocks to make interest payments. However, at maturity, the issuer must repay the principal and accrued interest in the form of cash. It makes PIK bonds highly risky debt instruments.

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PIK bonds provide flexibility to bond issuers. If these bonds are managed properly, the issuer can utilize the capital for business growth by saving cash reserves. However, if the issuer fails to repay at maturity, it can lead to further liquidity issues.

Example

Suppose a company ABC issues a $ 5 million PIK bond. It comes with a 5-year maturity. In the first two years, the company ABC would make 5% coupon payments “in-kind” and 3% in cash. For the remaining tenure, the coupon payments are deferred until maturity.

For the first two years, the investors would receive = $ 150,000 cash + $ 250,000 of new bonds.

For the next three years, the coupon payments at 8% would be accumulated. The company ABC will make accrued coupon payments and principal repayment at maturity.

Advantages of Payment-in-Kind Bonds

PIK bonds offer some advantages to issuers and investors.

  • Issuers can raise capital through PIK bonds in financial distress.
  • Issuers can save cash reserves for business growth.
  • Investors receive higher interest rates.
  • Investors have the option of receiving coupon payment-in-kind through warrants attached.

Disadvantages of Payment-in-Kind Bonds

PIK bonds are risky hence offer some disadvantages as well.

  • PIK bonds are an unsecured form of debt.
  • Issuers may face further liquidity issues if they cannot make repayment on time.
  • Investors may face a higher default risk with these bonds.

Final Thoughts

Payment-in-kind bonds make coupon payments in a form other than cash. These are unsecured bonds that do not come with collateral. Investors receive higher coupon payments in the form of bonds or preferred stocks. However, these bonds are risky for issuers and investors alike.

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