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PIK-ing holes - PIK bonds may have returned with a different structure but the risk is the same

11/10/2013

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

In Take your PIK, we argued the recent revival of interest in the curiously named PIK toggle bond, which has not been seen since the credit bubble burst, may imply a build-up of excess risk. As such, it was interesting to see ratings agency Moody’s has now published a report entitled, ‘A different flavour of PIKs’, which argues “aggressively structured PIK toggle bonds are back but they differ from bubble-era deals”.

Oh well, that’s all right then – apparently it’s different this time. Still, if four of the scariest words in investment are not enough to make you nervous, the report goes on to observe: “PIKs have been associated with high risk ever since [the credit bubble], but the new crop of PIKs differs in a number of respects from the bubble-era vintage.

“One thing has not changed, however: Today’s PIK issuers are just as leveraged as their bubble-era predecessors, so these deals still present significant risk to investors.” To put that another way, some of the structures around the bonds may have changed, but the level of borrowing – the risky bit that we highlighted in Take your PIK– has not.

Before the credit bubble burst, PIK toggle bonds tended to be used as a way of making up any gaps in funding when private equity firms took over companies. The difference between then and now is that, this time, the private equity firms already own the underlying companies and they are now looking to reissue the PIK toggle bonds as a way of taking a dividend on their investment.

So the company – the asset against which the bond is being issued – is still borrowing as much as it was before. Moody’s may be right when it says the new breed of PIK toggle bonds “differ from bubble-era deals” but the fact that this time the private equity firms are getting paid rather than the original owners of the companies matters a good deal less than the levels of debt involved.

Even the Moody’s report concludes: “the new PIK deals offer investors advantages over the older vintage, but they still expose them to significant credit risk. Restrictions on PIK elections, shorter tenors [maturities], and issuers with a history of deleveraging may present less credit risk for investors, but these benefits are balanced against highly aggressive capital structures.”

As a result, “all of the 2013 PIK issuances have very low ratings from Moody’s”. Well, they got there in the end. Interestingly, the report also notes most of the new PIK toggle bond deals have borrowings “similar to the bubble-era deals”. Of the deals completed in the first eight months of 2013, more than 80% had leverage of at least 6x EBITDA (earnings before interest, tax, debt and amortisation).

The thing is, in simple terms, debt is not paid down by EBITDA but by what you have left after paying all the i, t, d and a in that equation. in reality 6x EBITDA works out as roughly equivalent to 30x free cashflow – so 30 years to pay the debt off on current figures. That is extremely high and suggests people should be a little more worried about the return of the PIK toggle bond than they appear to be.

Author

Jamie Lowry

Jamie Lowry

Fund Manager, Equity Value

I joined Schroders in 2004 as an equity analyst in the European Equity Team initially specializing in the Industrial sectors before moving on to Consumer-based companies and finally Insurance. In 2007, I became a co-manager on a fund investing in undervalued European companies and took on sole responsibility for the fund in May 2010. Prior to joining Schroders, I worked at Hedley & Co Stockbrokers and Deutsche Asset Management as a trainee analyst.

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