Payment in Kind Bonds – Advantages, Disadvantages and its Types

In the past few articles, we have studied about different types of coupon payments. These coupon payments vary from each other a great deal. However, they all have one thing in common which is the fact that the interest is always paid in cash. However, payment in cash need not always be the case. There are certain special types of bonds in which borrowing companies have the option to pay the interest in kind. This is the reason that they are called “payment in kind” bonds. In this article, we will have a closer look at the various types of payment in kind bonds as well as their advantages and disadvantages.

What are Payment In-Kind Bonds?

Payment in kind bonds are bonds that provide the borrowing company with the flexibility of making interest payments by issuing more securities. This means that whenever the interest payment on the debt issue comes due, the company does not have to liquidate its cash. Instead, it can simply issue more securities in order to offset the accrued interest.

It needs to be understood that only periodic interest payments can be made in kind i.e. in the form of securities. However, when the actual principal becomes due, that has to be paid for in cash. This means that borrowing companies can issue additional securities in the interim. However, finally, they have to pay cash on maturity. The borrowing company can choose between bonds, preferred debt, and notes in order to make interest payments. However, most often the security chose to make such payment bonds themselves. Payment in kind bonds are issued by companies who do not want to have immediate pressure on their cash flow.

Advantages of Payment in Kind Bonds

Payment in kind bonds provide both investors as well as borrowing companies with some significant advantages. Some of these advantages have been mentioned below:

• Payment in kind bonds provide investors with higher returns with certainty. They generally have higher yields as compared to plain vanilla bonds

• Payment in kind bonds do not carry any reinvestment risk. This is because the bonds issued as interest generally carry a similar or a higher interest rate as compared to regular bonds

• Payment in kind bonds usually have covenants that prevent lenders from calling these bonds in the initial years. These bonds must be paid the agreed-upon interest for the first few years even if the market rates reduce drastically. Even if these bonds are called by the borrowing company, the fines and penalties levied will make up for the investor’s loss.

• The borrowing company can make long-term investment plans using funds issued by payment in kind bonds. This is because there are no immediate coupon payments. Hence, they are useful for firms that invest in projects that have high gestation periods.

Disadvantages of Payment in Kind Bonds

Payment in kind bonds are considered to be very risky. This is because they have some obvious disadvantages over other categories of bonds. Some of these disadvantages have been listed below:

• Companies that issue payment in kind bonds do not have to make any coupon payments for the first few years of the existence of the bond. Hence, there are greater chances of mismanagement of funds in the earlier period which ultimately leads to higher chances of default.

• From the company’s point of view, investors consider these bonds to be quite risky because of the higher risk of default. This is the reason that they often demand higher yields in order to park their funds in such bonds. Companies that use payment in kind bonds often do so because they do not have other options to raise funds in a more cost-effective manner

• Payment in kind bonds are closely related to junk bonds. This is because payment in kind bonds are also issued by companies that have poor financials. These bonds are considered to be a kind of mezzanine debt that provides borrowers with relief since they do not have to make immediate payments.

• Payment in kind bonds tends to attract high-risk investors such as hedge funds. The problem is that a lot of these investors make speculative bets in the market. Hence, the number of people holding the payment in kind bonds to maturity is very less. The investors are constantly flipping these bonds trying to make a higher profit. As a result, the secondary market for these bonds is very volatile and price fluctuations are common in this market.

• Payment in kind bonds are considered by many companies to be a form of a financial quick fix. This is because the bonds provide interim relief which results in liquidity problems being masked away. However, in the long run, the problems continue to exist and in a lot of cases, these bonds may exacerbate the extent of the problem.

• Payment in kind bonds aggravates the credit exposure of the investors to the firm. Since interest gets paid in the form of additional bonds, companies end up owing more to the investors than they begin with. This could lead to risk management problems for the investors themselves as they may be over-exposed to certain types of risks.

• Most payment in kind bonds are not backed by any hard asset as collateral. This fact along with the delayed cash flow makes them exponentially riskier.

As we can see from the points mentioned above, the disadvantages of payment in kind bonds vastly outnumber the advantages of such bonds. Hence, it can be said that these bonds are considered useful by a very specific clientele.

Types of Payment in Kind Bonds

Firstly, it is important to understand that not all payment in kind bonds is the same. There are multiple variations of the payment in kind bond. Let’s have a look at these variations below:

1. Toggle Bonds: Toggle bonds are a variation of payment in kind bonds. These bonds give the investor an option as to choose whether they want to accept a cash repayment or whether they accept payment in kind. These bonds have two different interest rates on offer. For instance, they may offer 5% interest if cash is redeemed and at the same time, they may offer 6% interest if payment in kind is accepted. These types of bonds try to lure investors into voluntarily accepting payment in kind instead of making it compulsory for them.

2. Holdco PIKs: Holdco payment in kind bonds, as the name suggests, are offered by the holding companies. They are not offered directly by the operating companies. Now, as per legal principles, the operating companies have to first service the debt which they have directly undertaken. After that, if any cash flow is left over, then that additional cash flow can be passed over to the holding company. This means that holding company payment in kind bonds are actually structurally subordinated to the debt of the operating company. This means that the chances of default are much higher since this debt is very low in the seniority structure and may only be above equity. Also, investors of Holdco bonds need to be aware of the covenants which restrict the amount of cash flow between related parties.

3. Pay If You Can: Another variation of payment in kind bonds are called pay-as-you-can bonds. Just like toggle bonds, these bonds also give an option. However, this time, the option is given to the issuing company. If they have additional cash flow, they can pay off these bonds in cash. However, if they do not have additional cash flow, then they can issue more bonds in lieu of cash in order to make interest payments. The rates for cash and kind payments can be different based on the covenants present in the bond indenture.

Taxation for Payment in Kind Bonds

Payment in kind bonds can often lead to more advantageous outcomes for the investors holding the bonds. This is largely because of the fact that in most parts of the world capital gains taxes are charged at a lower rate as compared to income tax. When investors receive regular income in the form of a coupon payment, it is taxed at a higher rate. However, when the same investor receives additional bonds in lieu of interest and they earn money by selling those bonds, then the income so generated is considered to be capital gains and is taxed at a lower rate.

Payment In Kind Bonds and Leverage

The issuing of payment in kind bonds by certain organizations may be considered to be dangerous. This is particularly true if the total debt of these organizations is hovering around the maximum debt which is allowed by covenants of their other bonds. In such cases, they may not be able to issue more bonds in lieu of interest since if they do so, then they will exceed the upper cap on leverage.

Accounting for Payment In-Kind Bonds

Payment in kind bonds can be advantageous for the issuing firm also. This is because accounting works on the principle of accrual. This means that the interest is recognized when it becomes due. The fact that interest is not paid out immediately is irrelevant to the calculation. Hence, as soon as the interest gets accrued, it is recognized as debt on the balance sheet. This also means that the expenses go up by that amount. As a result, the company pays a lower tax.

Hence, it can be said that payment in kind bonds provide a tax shield to the company. Since debt is used to lower the tax at the accrual stage, it may not be available to lower the tax when it is actually paid out. However, this is not important since because of the time value of money, the company ends up in a more advantageous position by saving the tax upfront.

However, payment in kind bonds often lead to balance sheets becoming bloated. This is because of the fact that the accrued interest immediately increases the liability of the company. The cash is only increased by the amount of tax saved. The balance amount results in a deduction to equity. Hence, payment in kind debt has an immediate negative effect on the net worth of the organization.

The bottom line is that payment in kind debt has many variations and each variation has its own set of advantages. Also, the taxation and accounting treatment of these bonds is different given the different nature of these bonds.