PIK toggles must improve transparency

Author: Danielle Myles | Published: 15 Nov 2013
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  • Buyside credit analysts need clear definitions regarding coupon conversion and calculation of the net income basket in European PIK toggle deal documentation;
  • The warning comes as year-to-date European PIK issuances reach a record high, exceeding full-year 2012 volume by eight times;
  • The toggle feature is major distinction between this PIK market and the previous cycle that peaked in 2006-2007;
  • Lawyers say the deal structures are more conservative than before, however, with more stringent rules on when coupons are paid in cash or in-kind.

Credit analysts need clearer definitions in payment-in-kind (PIK) bond documentation to accurately assess deals.

The number of caveats in recent deals, combined with this year’s new-style toggle feature, has forced investors to seek confirmation from issuers on the formula that determines when the coupon will switch from cash-pay to PIK-pay.

European PIK issuance has reached an all-time-high, with Fitch revealing that year-to-date volumes are eight-times that of 2012 levels. But comments by the investor community at this week’s Association for Financial Markets in Europe High Yield Conference suggest it is a market still needing to mature.

"While we are certainly open-minded to cash-pay PIKs, I don’t think we have got the proper transparency yet to really understand what we are investing in," said panellist Nancy Utterback, senior credit analyst with Aviva Investors.

Further reading

Polkomtel PIK: a sign of things to come?

No renaissance for PIKs yet

Are investor protections in high-yield notes being eroded?

The biggest problem, she said, was lack of clarity surrounding definitions regarding the toggle feature in the deal documentation. The excessive number of caveats in definitions has forced investors to ask management to clarify the specifics on how to calculate the net income basket.

This, however, can be met with an obscure response. "Sometimes management report what the basket itself is, but we need the calculation [to assist going forward]," said Utterback.

Panellist Fred Kooij, head of European high yield research at BlueBay Asset Management, noted that the prevalence of the toggle feature is a key difference between the 2013 market compared to the peak of the previous cycle, six or seven years ago.

Given toggles give the issuer the ability to pay coupons in additional bonds or cash, with PIK interest being accrued at a higher rate than cash interest, the feature has a significant impact on deal pricing.

As such, another investor panellist noted that calculating the likelihood of the toggle mechanism being activated is credit analysts’ most difficult task.

But while they are considered riskier than pure PIK notes, many of this years toggle deals have included more stringent and noteholder-friendly rules on the coupon payment.

"I think it is important to note that while there have been a lot more PIK bond issuances this year, they have been more conservatively structured and have generally come from solid credits," said panellist Jaenette Cruz, partner at Allen & Overy.

For example, German car company Schaeffler’s €800 million ($1.28 million) PIK toggle in July – Europe’s biggest this year – requires the issuer to pay cash coupons during certain interest periods.

CRA and investor scepticism

PIK toggles have received a lukewarm reception from credit rating agencies.

"From our perspective, we don’t really like PIK toggles, but it does fundamentally depend on where it takes the total leverage in the deal," said panellist Paul Watters, head of corporate research at Standard & Poor’s Ratings.

While a company that has delevered and then subsequently issued a PIK to pay a dividend is one thing, opportunistically taking advantage of liquidity in the market and taking leverage up a turn is, Watters said, another thing entirely.

"We are always looking at it from the perspective of the glass being half empty," he said. "If you have the option of paying cash we presume you will always pay cash, and so we reflect that in the metric, and that will have an impact on a consolidated basis."

Despite this year’s record volumes, some investors are wary of the full family of PIKs, which are usually deeply subordinated and fare poorly in a distressed scenario.

"One of the major issues we have is just the asymmetry of risk," said one, speaking at yesterday’s event. "The returns are generally not appropriate given the risks they take in terms of what they can control if things do go wrong."

Upon the onset of the financial crisis, PIK noteholders learned they were left in a largely powerless position if the issuer unravels.

"I can’t think of a particular solution when a PIK has done well in a restructure," said the panellist. "Generally, we don’t think much has changed [compared to the 2005-2007 vintage] and so we are very sceptical to invest in PIKs."

See also:

Polkomtel PIK: a sign of things to come?

No renaissance for PIKs yet

Are investor protections in high-yield notes being eroded?