Payment-In-Kind (PIK) Bonds: Definition and How Interest Works

What Is a Payment-In-Kind (PIK) Bond?

A payment-in-kind (PIK) bond refers to a type of bond that pays interest in additional bonds rather than in cash during the initial period. The bond issuer incurs additional debt to create the new bonds for the interest payments. Payment-in-kind bonds are considered a type of deferred coupon bond since there are no cash interest payments during the bond's term.

The risk of default by PIK bond issuers tends to be higher, which is why they normally have higher yields. The majority of investors who park their money in PIK bonds are institutional investors.

Understanding Payment-In-Kind (PIK) Bonds

Payment-in-kind is used as an alternative way of paying cash for a good or service. With a payment-in-kind bond, no cash interest payment is made to the bondholder until the bond is redeemed or the total principal is repaid at maturity. It is a form of mezzanine debt that lessens the financial burden of making cash coupon payments to investors. On the dates when the coupon payments are due, the bond issuer pays the accrued interest on the PIK debt by issuing additional bonds, notes, or preferred stock. The securities used to settle the interest are generally identical to the underlying securities, but on many occasions, they may have different terms. Because there is no regular income, investors seeking cash flow or regular income should not purchase payment-in-kind bonds.

PIK bonds typically have maturity dates five years or more and are unsecured, meaning they are not backed by assets as collateral. Companies that issue PIK bonds may be financially distressed and their bonds may have low ratings, but they normally pay interest at a higher rate. Because PIK bonds are an unusual and high-risk product, they mainly appeal to sophisticated investors such as hedge funds.

These kinds of bonds were generally popular when private equity began to boom in the early- to mid-2000s. They began to lose their luster when the global financial crisis hit.

PIK vs. Regular Bonds

Some bonds are issued with interest rates, which, in fixed income terminology, are called coupon rates. Investors receive coupon payments semi-annually which are a form of return on investment (ROI) for the bond investor. So a bondholder who purchases a bond with $1,000 face value and 4% coupon that pays semi-annually will receive $20 (½ x 4% x $1,000) in interest income twice a year. The lower the credit rating on the issuing entity, the higher the yield investors can expect on the bond.

Investors who purchase low-grade bonds are faced with the risk of the issuer defaulting on the payments. An issuer who runs into liquidity problems has the option of delivering more bonds in the form of additional principal to the bondholder for an initial period of time. This gives the bond issuer some breathing room from having to make interest payments to bondholders. Sometimes the investor has the option of receiving his or her coupon payments in cash or kind. Coupon payments received in the form of additional bonds are referred to as payment-in-kind bonds.

Advantages and Disadvantages of PIK Bonds

Issuing PIK bonds is an option for many companies that experience cash flow or liquidity problems. By doing so, bond issuers can forgo having to make cash payments on the coupons to bondholders. They may find some relief in the more immediate term and free up some cash for other, more necessary areas.

While it may seem like a boon, issuing PIK bonds can be a problem. That's because it makes the company overleveraged, adding to the firm's existing debt load and its liquidity problems. Issuing PIK bonds doesn't alleviate the firm of its debt, it only pushes the obligation to a future debt. If it hasn't solved its liquidity problems by that point, it may run into the risk of default.

Example of a PIK Bond

PIK bonds result in more debt that needs to be repaid by the issuer. The principal amount to be repaid increases every year, putting the issuer at risk of liquidity. The increase in financial leverage taken on by the issuing company also increases its risk of default.

Let’s assume a company issues a corporate bond with a principal amount of $10 million due to mature in seven years. The terms of the bond include a 9% cash coupon payment and 6% PIK interest to be paid annually. In the first year, bondholders will receive a cash payment of $900,000 (9% x $10 million), while $600,000 (6% x $10 million) is paid in additional bonds. This increases the principal amount of the issue to $10.6 million ($10 million $600,000). This continues to be compounded until the end of the seventh year. At this point, the lender will receive the payment-in-kind interest in cash when the bond is paid at maturity.

The Bottom Line

For companies facing liquidity issues, payment-in-kind (PIK) bonds represent a convenient way to raise capital without having to redirect its cash flows on repayment. However, this type of bond ultimately increases the amount of principal that must be repaid in the long run. PIK bonds have higher yields than conventional bonds, but they also come with greater risk.