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With safeguards built in, PIK-toggle bonds rise again

A new surge of payment-in-kind bond deals is alarming at first sight. Investors should be wary of bonds that can pay IOUs in lieu of interest. But recent issuance, often to fund dividends to private equity firms, doesn't yet look like a rerun. The so-called "PIK-toggle" note offerings have protections built in that should help keep reckless behaviour in check.

Companies have sold $4.4-billion (U.S.) of PIK-toggles in the United States this year as of Oct. 24, according to Standard & Poor's Leveraged Commentary & Data. That's the most since 2008, and in line with issuance in 2006 when the instruments first gained popularity. Recent issuers include TransUnion, the credit bureau acquired for $3-billion earlier this year by Advent International and GS Capital Partners, and pet supply firm Petco, owned by private equity firm Leonard Green.

About a third of PIK-toggle bonds issued in the pre-crisis credit boom ended up defaulting in 2009, according to Moody's Investors Service. That's partly a function of high debt levels in general, which eventually brought down companies like casino operator Harrah's. But PIK structures can also allow a troubled company to get even deeper into a hole, making any recovery for creditors even slimmer.

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It seems that the lessons are being remembered, at least for now. Many deals, including the $400-million of bonds sold by TransUnion last month, restrict how much interest can be substituted with new debt. Rating agency S&P reckons investors in the TransUnion bonds will most probably receive cash, not extra PIK notes, thanks to restrictive terms.

Still, the structure is risky. TransUnion's debt now adds up to more than six times EBITDA. And the new crop of PIKs rank lower in an issuer's capital structure than regular debt, meaning creditors' claims on assets are weaker. And many, like the TransUnion bonds, can be called within two years, potentially diminishing the upside for bondholders.

Those features, of course, mean borrowers pay more. According to Citigroup, spanking new PIK-toggles are bringing investors a three-percentage-point bump in yield over existing bonds, compared with only a little more than a tenth of that in the previous cycle. That's appealing for hungry investors, who are also snapping up high-yield debt. At least they're taking some precautions, so far, to ensure private equity-owned firms don't go hog wild on debt.

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