BIS Rings Alarm on Record Payment-in-Kind Junk Bond Sales

Record sales of high-yield payment-in-kind bonds are triggering uneasiness among international regulators concerned investors may suffer losses when central banks tighten monetary policy.

Issuance of the notes, which give borrowers the option to repay interest with more debt, more than doubled this year to $16.5 billion from $6.5 billion in 2012, according to data compiled by Bloomberg. About 30 percent of issuers before the 2008 financial crisis have since defaulted, the Bank for International Settlements said in its quarterly review.

Companies are taking advantage of investor demand for riskier debt as central bank stimulus measures suppress interest rates and defaults approach historic lows. The average yield on junk-rated corporate bonds fell to a record 5.94 percent worldwide in May, Bank of America Merrill Lynch index data show, while global default rates dropped to 2.8 percent in October from 3.2 percent a year earlier, according to a Moody’s Investors Service report.

“Low interest rates on benchmark bonds have driven investors to search for yield by extending credit on progressively looser terms to firms in the riskier part of the spectrum,” according to the report from the Basel-based BIS. “This can facilitate refinancing and keep troubled borrowers afloat. Its sustainability will no doubt be tested by the eventual normalisation of the monetary policy stance.”

The BIS was formed in 1930 and acts as a central bank for the world’s monetary authorities.

Biggest PIK

Sales of payment-in-kind bonds last peaked in 2007 when companies issued $11.1 billion of the securities, Bloomberg data show. Offerings fell to $5.4 billion in 2008 and tumbled to $2.7 billion in 2010, the data show.

Schaeffler Holding GmbH & Co. was the biggest PIK issuer this year, selling an equivalent $2 billion of five-year notes in dollars and euros that pay a coupon of 6.875 percent, according to data compiled by Bloomberg. The German industrial-bearing maker said it issued the bonds as part of a 3.875 billion-euro ($5.3 billion) refinancing agreement.

The yield on the euro notes fell to 5.32 percent from 6.27 percent when they began trading on July 23, according to data compiled by Bloomberg. The yield on the dollar bonds has dropped 1 percentage point to 5.43 percent.

Schaeffler is rated B1, or four steps below investment grade, at Moody’s.

Corporate bonds in euros rated single B returned 9.3 percent this year compared with 2.3 percent for investment-grade bonds, according to Bank of America Merrill Lynch data. Lower rated debt performed even better, with those bonds ranked CCC or below handing investors 13.7 percent, the data show.

To contact the reporter on this story: Katie Linsell in Madrid at klinsell@bloomberg.net

To contact the editor responsible for this story: Shelley Smith at ssmith118@bloomberg.net

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