Payment-in-Kind Note Offerings Pick Up

Bubble-era financing method makes a comeback as concerns mount about corporate profits.

A type of financing that peaked before credit markets seized up four years ago is staging a comeback just as concern mounts that corporate profits are falling and the global economy is losing steam.

Offerings of $2.1 billion in the past 30 days of so-called payment-in-kind notes, which allow borrowers to pay interest with extra debt, account for more than a third of this year’s $6 billion of deals, according to data compiled by Bloomberg. Pharmaceutical Product Development Inc., a Wilmington, North Carolina-based contract research firm, sold $525 million of the notes yesterday.

Sales of high-yield, high-risk bonds are soaring to a record pace as interest rates hover at unprecedented lows send investors toward riskier assets. JPMorgan Chase & Co. says credit metrics are deteriorating, with leverage at investment-grade borrowers potentially approaching financial crisis levels by year-end, as the International Monetary Fund lowers its global growth forecast to the slowest pace since 2009.

“You only hear about PIK bonds when the high-yield markets are really frothy,” William Larkin, a fixed-income money manager who helps oversee $500 million at Cabot Money Management Inc. in Salem, Massachusetts, said in a telephone interview. The trend “is OK if we’re at that part of the cycle where things start to accelerate. But we don’t know that.”

Even as issuance of PIK bonds accelerates, sales are below the record $14.9 billion in 2007, Bloomberg data show. Sales fell to $14.5 billion the following year, as the failure of Lehman Brothers Holdings Inc. led to a credit freeze.

Relative yields on high-yield bonds reached a record 21.82 percentage points on Dec. 15, 2008, from that year’s low of 6.1 percentage points on Jan. 2, Bank of America Merrill Lynch index data show. Spreads have fallen to 5.61 percentage points as of yesterday.

“The increased use of payment-in-kind structures is confirmation that this is a sellers’ market,” Edward Marrinan, macro credit strategist at RBS Securities in Stamford, Connecticut, said in a telephone interview. “Many issuers are in a position to dictate terms to investors.”

Elsewhere in credit markets, Moody’s Investors Service cautioned investors on risks in a JPMorgan commercial-mortgage bond deal. Mizuho Financial Group Inc. raised $2.5 billion in its third benchmark dollar-denominated debt sale this year. Online services company Endurance International Group Inc. is said to be seeking $1.12 billion of covenant-lite loans, or debt that doesn’t contain typical creditor protections.


Default Swaps

The cost of protecting corporate bonds from default in the U.S. rose. The Markit CDX North America Investment Grade Index, which investors use to hedge against losses or to speculate on creditworthiness, climbed 0.5 basis point to a mid-price of 99 basis points, the highest since Sept. 28, according to prices compiled by Bloomberg.

The Markit iTraxx Europe Index of 125 companies with investment-grade ratings dropped 1.25 to 132 at 10:25 a.m. in London. In the Asia-Pacific region, the Markit iTraxx Asia index of 40 investment-grade borrowers outside Japan eased 1.2 to 131 basis points.

The indexes typically rise as investor confidence deteriorates and fall as it improves. Credit-default swaps pay the buyer face value if a borrower fails to meet its obligations, less the value of the defaulted debt. A basis point equals $1,000 annually on a contract protecting $10 million of debt.

The U.S. two-year interest-rate swap spread, a measure of debt market stress, reached the lowest level since March 2010, falling 0.34 basis point to 12.12 basis points. The measure narrows when investors favor assets such as corporate bonds and widens when they seek the perceived safety of government securities.

The ratings on two investment-grade portions of the $1 billion commercial-real estate deal sold by JPMorgan Sept. 27 are too high because they don’t include a sufficient cushion against losses, Moody’s said in a report yesterday. One of the classes would likely garner a speculative-grade ranking from the New York-based ratings firm, Moody’s said.

The offering was the first deal rated by Standard & Poor’s since that rater derailed a $1.5 billion sale by Goldman Sachs Group Inc. and Citigroup Inc. last year by pulling its grades on the securities. JPMorgan selected S&P to grade its deal after the company, seeking to regain market share, completed an overhaul of methods for analyzing bonds linked to skyscrapers, shopping malls and hotels last month.



In emerging markets, relative yields widened 2 basis points to 297 basis points, or 2.97 percentage points, according to JPMorgan’s EMBI Global index. The measure has fallen from this year’s high of 441 on Jan. 13.

Bonds of state oil company Petroleos de Venezuela SA were the most actively traded dollar-denominated corporate securities by dealers yesterday, with 313 trades of $1 million or more, according to Trace, the bond-price reporting system of the Financial Industry Regulatory Authority. The debt is the most traded in the U.S. this week after President Hugo Chavez’s re-election on Oct. 7.

Demand for PIK bonds underscores investors’ appetite for riskier assets. Sales of junk bonds in the U.S. are proceeding at an unprecedented pace, with issuance of $259.9 billion exceeding the $210.6 billion sold in the corresponding period of 2010, the busiest year on record, Bloomberg data show.

Yields on U.S. corporate bonds reached a record low 3.676 percent on Oct. 3, before climbing to 3.682 percent as of Oct. 9, according to the Bank of America Merrill Lynch U.S. Corporate & High Yield Master.

PIK toggle bonds allow borrowers to elect to pay interest in cash or through issuing more debt, or a combination of the options, generally within the first few years of the bond’s term, according to Moody’s.

Pharmaceutical Product’s offering was increased by $25 million from the $500 million initially planned, Bloomberg data show. The five-year debt pays 9.375 percent in cash and 10.125 percent if the company pays in the form of additional debt.

Jo-Ann Stores Inc., based in Hudson, Ohio, sold $325 million of seven-year PIK notes on Oct. 9 that pay 9.75 percent in cash and 10.5 percent if the company pays in added debt, Bloomberg data show.

Five days earlier, Petco Animal Supplies Inc., owned by Leonard Green and TPG Capital, raised $550 million selling five-year debt that pays 8.5 percent in cash and 9.25 percent if paid in added debt.

The debt from all three borrowers is rated Caa1 by Moody’s and CCC+ at S&P. Ned Glascock, a spokesman for Pharmaceutical Product, declined to comment on the offering. Representatives of Jo-Ann and Petco didn’t return telephone calls seeking interviews.

The securities provide issuers with flexibility if the economy weakens or the companies struggle to make cash interest payments, Sabur Moini, who manages about $2.5 billion of high-yield assets at Payden & Rygel in Los Angeles, said in a telephone interview. Hedge funds and other investors that favor riskier assets are typical buyers.

Investors find PIK securities appealing with the global speculative-grade default rate of 3 percent in September below the historical average of 4.8 percent in data going back to 1983, according to Moody’s.

Leverage metrics in investment-grade bonds are likely to have weakened in the third quarter because of a drop in earnings and a rise in debt, analysts led by Eric Beinstein at JPMorgan wrote in an Oct. 9 report. Leverage reached 1.98 times in the second quarter, compared with a crisis high of 2.11 in the third quarter of 2009 and a low of 1.86 in fourth quarter of 2010.

“There is little doubt that credit metrics will deteriorate further” in the third quarter, according to the report. “We would not be surprised to see leverage move back near the crisis peak again” in the third quarter of by the fourth quarter.

The world economy will grow 3.3 percent this year, the slowest since the 2009 recession, and 3.6 percent next year, the IMF said Oct. 9, compared with July predictions of 3.5 percent in 2012 and 3.9 percent in 2013. The Washington-based lender now sees “alarmingly high” risks of a steeper slowdown, with a one-in-six chance of growth slipping below 2 percent.

Third-quarter profits and sales for companies in the S&P 500 probably fell in unison for the first time in three years, according to analysts’ estimates compiled by Bloomberg. Per-share earnings may have dropped 1.7 percent on average after they were little changed in the second quarter. Sales may have slipped 0.6 percent, the data show.

While PIK bonds may perform for a while, “when they stop performing well they become virtually unsellable at times, and they can drop in price rather substantially,” James Kochan, chief fixed-income strategist at Wells Fargo Funds Management LLC in Menomonee Falls, Wisconsin, said in a telephone interview.


 Bloomberg News


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