Take your PIK – The reappearance of a little-known type of bond hints at risk in the system
Finance and risk go hand in hand but, while some risks can be apparent to everyone, others are not. The US credit markets are often an excellent place to spot any build-up of excess risk, so that is where we will turn to illustrate our point – and specifically to a little-known financial instrument called the PIK Toggle bond.
To explain the unusual name, the ‘PIK’ stands for ‘payment in kind’ and the ‘Toggle’ refers to the ability of the issuer to elect whether it pays interest on the bond in cash or by rolling it up into new debt – effectively as an ‘IOU’. From this you can see why issuers are so fond of PIK Toggle bonds and why lenders should perhaps use them with greater care.
The last time PIK Toggle bonds were being used was the very peak of the credit crisis – from which we may tease out two points of interest. The first of these, as can be seen from the graph below, is that the median leverage ratio for high-grade US companies – that is, the ratio of debt to earnings –recently surpassed the peak levels of 2009.
Source: Citi Research, Bloomberg as at 31st March 2013
The other point is that the first occasion on which a PIK Toggle bond could appear since the credit crisis is expected to be as part of the financing deal that will see US luxury retailer Neiman Marcus taking itself private – and, oddly enough, it was Neiman Marcus who started the trend for PIK Toggle bonds back in 2005 when it was originally bought out.
Nor is this a purely US phenomenon – as demonstrated by the recent announcement that Phones 4u is to offer a PIK Toggle bond in the UK. Still, to return to Neiman Marcus, on a like-for-like comparison, the leverage on its new deal is significantly higher than it was back in 2005 – and The Value Perspective does not need to remind you what was just around the corner.
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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