Are pure PIK bonds' payoffs known from the start?

Question

I am developer working in the financial field and I would like to understand what I'm doing.

My latest work subject involves Payment In Kind bonds with coupons fully reinvested (e.g, no coupons partially received as cash, so, a Deferred Interest Bond). As I understand these assets, they "sort of" pay you coupons, but in the form of increasing the nominal of the bond, in a way fully determined at the emission of the bond.

Forgive my simplistic view of things, but isn't that precisely what Y Zero-coupon bonds with maturity T of market price X/Y do ? Pay X on date 0, receive Y on date T, Y is known from the start. End of story.

I hardly care about what Y represents and that it was obtained by simulating reinvested periodic coupons. Assuming that Y is predetermined, I fail to see the reason PIK bonds exist. I was told that PIK bonds and Zero-coupon bonds were "Very different in accounting", but I also don't see why they would be. From date 0 to date T, you are in the same situation of being supposed to receive Y on date T.

On the dates when the coupon payments are due, the accrued interest on PIK debt is paid through the additional issuance of bonds, notes, or preferred stock. - Investopedia

Therefore, for these bonds to have a reason to exist, I would expect Y to not be known from the start. Is that the case, and if it is : what actually happens when a "coupon" is paid ? If additional bonds issued by the PIK bond issuer are used to pay, does the bond yield depend on the current yield investors ask of this company ?

Thanks.

Answer 1

In the most common version of a PIK bond, the PIK schedule is known in advance. The coupons are typically fixed; the prospectus says that certain coupons will include some PIK and some cash. Effectively the bondholder receives more bond. The face value does not change, but the factor increases. For example, look up DOMREP 9.4% 2018 bond (ISIN USP3579EAD96). Some early coupons are all capitalization. Next, some are part capitalization and part cash; and then all cash. Operationally, PIK is not quite the same as the opposite of amortization (sinking fund). Recall then when a bond amortizes, the face value remains the same, but the factor drops at the time of amortization. The face value of a PIK bond also does not change, but the factor increases; and unlike amortization, the factor increases by a small amount every day. If you have Bloomberg, try "BXT" on the above example for different past settlement dates. You will see not only the cash accrued that changes daily, but also accrued PIK and the factor changing every day. Clearly, the economic motivation for issuing bonds like these are: the borrower needs some capital now and cannot afford to pay coupons; the bond holders are willing to accept less coupon cash flows now and a lot more later (if the issuer does not default). The cash flows are actually comparable to those of a bond with very long first coupon period and/or a step-up coupon rate, just the term sheet language is different; and the tax treatment of the PIK may differ a little. There are a couple of situations where the PIKs are not known from the start. A few high-yield bonds have optional PIK, that is, the issuer decides for each coupon whether to pay all cash (the most beneficial to him, if he has the money) or some or all in kind (which is more beneficial to (long) bondholder - if eventually the issuer pays more, rather than defaults). In this case, you should know the historical coupons (or at the very least, the factor at the beginnin of the current coupon) and whether the current coupon is all cash or some PIK. Sometimes you can be very certain that the issuer will exercise the option and the next coupon will be PIK, but most of the time you don't know. Even when exercising the option seems to make economic sense (the issuer effectively forces the bondholders to loan him a little more money at the same terms as the original bond; while borrowing money in the market might be more expensive), the issuer would be reluctant to exercise the option because it sends a very bad signal to market - the the issuer cannot afford to pay coupons. In the example you describe - all coupons are PIK, and then everything is paid at maturity - indeed the cash flows are like those of a zero-coupon bond (but taxation may be different), but I've never seen such a bond and can't imagine what would motivate someone to do this. if the issuer has been capitalizing all the coupons up to maturity instead of paying cash coupons, I would expect the issuer not to have the money to pay at maturity either (i.e. to default). Historically, there also have been a few PIK floaters, where the PIK amount depended on the LIBOR index at the time of the coupon. I don't believe there are any left now.