Payment-In-Kind Bonds Deliver No Payment

According to the Wall Street Journal, more and more companies that issued PIK toggle bonds during the private equity boom are opting to pay investors more debt rather than interest. For those unfamiliar with PIK toggles, it is debt issued with the option to substitute interest payments for more debt. The option resides with the issuer, of course, not the investor. This structure was very popular during the peak of the private equity boom when debt investors were tripping over themselves to pay absurd prices for leveraged loans. Private equity sponsors took full advantage of the deluge of cash at the time by issuing bonds with PIK toggles to give themselves a little breathing room in case the companies ran into liquidity problems in the future. What does a company with liquidity issues need more than anything else? I'll let you in on little secret: it is not more debt. Granted, not having to make an interest payment is a temporary respite from possible bankruptcy, but it only delays the inevitable.
Seven companies have taken advantage of the PIK toggle option on $2.4 billion in bonds so far. Claire Stores, a retailer taken public by Apollo a year ago, is a prime example. Claire Stores bonds now trade at $.58 on the dollar. Investors were absolutely shocked! Personally, I would be shocked if every single PIK toggle bond issued didn't end up eventually taking this option. It's like asking how many people who took out option arms expected to make the full payment on their mortgage. The answer? Zero. Why? Because none of them could afford to make the full payments in the first place. This is why default rates on option arms are skyrocketing. Anyone with half a brain should have expected the same out of the companies that issued PIK toggle bonds. Leveraged loan investors who bought into these loans deserve exactly what they are getting: no cash, just a tenuous IOU.