PIK Your Poison

 - By Matthew Sheahan -

PIK Toggle notes have come back in a big way this year, with the volume of PIK notes issued on the junk bond market as of the last week of April, surpassing the totals of the last two years, according to Fitch Ratings. And market observers don't see this trend as good news.

Issuers have priced a total of $2.4 billion of payment-in-kind toggle notes so far this year, topping the 2009 total of $875 million and the 2010 total of $531 million, according to Standard & Poor's. The volume, while well off the pace of the nearly $20 billion in PIK notes priced at the height of the market in 2007, still serves as a red flag to some.

"It's another clear indication that the corporate bond market is running out of steam," said Anders Maxwell, a managing director with Peter J. Solomon Co. "When you resort to this kind of gimmickry, it's another bellwether indication that the market has topped out."

The appearance of these deals indicates that companies are beginning their quest for financing with the concession that they may not be able to service their debt with cash, sources say. "Guns don't kill people, people kill people; and PIK Toggle notes don't kill companies, inadequate cash flow kills companies," said Jeffrey Werbalowsky, co-CEO of Houlihan Lokey. "The elements that induce people to borrow through a PIK Toggle mechanism are indicative of the fact that there is insufficient present cash flow to service those obligations. People are relying on a future increase in cash flow."

Among the recent PIK issuers, Philadelphia-based food services company Aramark sold $600 million in the notes at a discount on April 4. The company is using the proceeds, in part, to finance a dividend payment to private equity owners GS Capital Partners, JPMorgan Partners, Thomas H. Lee Partners and Warburg Pincus.

Other companies to price PIK deals within the last two months include CKE Restaurants, Bumble Bee Foods, and American Renal Holdings -- all of which are also private equity backed.

Evidence from the wave of PIK notes during the buyout boom indicates that investors are right to worry about the state of the market with an increased PIK presence. A Moody's Investors Service study of deals priced mostly during the credit bubble shows that these notes had an average default rate of almost 30% in 2009. Similarly, rated non-PIK issues had a default rate of 17 percent. PIK issuers were also more likely to have their ratings downgraded to the Caa and Ca categories from the single-B category. Most of the defaults among PIK Toggle issuers occurred because of distressed exchanges and Moody's points out that almost 90% of these companies were controlled by LBO firms, which were able to protect their equity through the exchanges.

But there are signs that the current crop of PIK deals may have some upside that the previous generation did not have. With the exception of the Aramark deal, which used proceeds to pay a dividend, funds from this year's PIK Toggle offerings have almost always gone to refinancing and recapitalization. Whereas the majority of PIK notes priced in the 2006 through 2008 time frame were for M&A, recapitalization and refinancing make up nearly 100% of the purposes of PIK notes in 2010 and so far in 2011, according to S&P.

Another difference between the current breed of PIK notes and their credit bubble predecessors is that they are likely to have a higher coupon. "The market has a short memory but not that short, so it's built in a little bit of a cushion compared with a couple of years ago," said Darin Schmalz, a director with Fitch.

Adam Cohen, founder of research firm Covenant Review, said that while covenants remain the same for PIK notes issued this year versus in years past, there is more likely to be an equity market motivation for pricing them. "Some of the PIK deals now are in place of or in anticipation of an IPO," said Cohen. "By comparison, the 2007 deals often happened quickly after the LBO to effectively reduce the amount of equity."

And companies are being aggressive about taking out their PIK debt. "You're starting to see issuers take out, through tender offers and buy backs, more aggressive double-digit coupons and PIK toggle notes," Schmalz said. The most recent company to make a tender offer for PIK notes is Allison Transmission, which launched a cash tender offer for $505 million in outstanding 11.25% toggle notes due 2015 on April 15.

PIK issuers are also benefiting from a low default rate. "People don't expect another spike in defaults anytime soon," said Schmalz. "People are looking at the general economy and factoring in a slow growth scenario and that shouldn't lead to any type of economic recession or depression anytime soon. ...Given that slow-growth scenario, these are attractive."

Still, investors warn that timing the market is always dangerous, and that the current increase in PIK notes is a function of an abundance of cash sitting in mutual fund coffers and interest rates kept artificially low by the Federal Reserve.

"It all works when it works, but these are indicative of Wall Street taking another step out on the risk-return tightrope because the teeming crowds of investors desperate for yields are cheering them on," said Houlihan Lokey's Werbalowsky.

He adds it's a story that has played out before. "People are not being stupid; they are rationally following their own individual incentives. .... There are lots of investors who think PIK Toggle notes do not make sense, but there's such a substantial pool of receptive investment capital out there and high yielding investments are so relatively small that people are making the usual rationalizations."

High yield bond buyers are facing pressure from investors in their funds to put money to work in higher-yielding securities. If they don't, they face angry investors who see other firms accessing yield. "You can be conservative and right in a fund ... all the way until you're out of business," Werbalowsky said.

And investors agree that the increased presence of PIK notes is potentially a sign of an oncoming downturn. "The PIKs arrive as the party's about to end," said Maxwell. "That's the way it's always worked."

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