Red-Hot Market Spurs Risky Bonds That Allow Interest Delays

  • Deals give borrowers option to defer interest payments
  • Schaeffler poised to issue the largest ever bond of this kind

The bond market is getting so hot that it’s fueling a surge in debt deals allowing companies to defer interest payments.

Just a week in, September is already on track to become the busiest month for so-called payment-in-kind toggle notes that let companies pay coupons with more debt, according to data compiled by Bloomberg. Ardagh Group SA, a Luxembourg-headquartered packaging company, sold $1.72 billion of the securities. German auto components maker Schaeffler AG is poised to sell 3.59 billion euros ($4.05 billion) of the notes on Thursday, more than 1 billion euros than initially planned, which would make it the largest PIK issue ever, Bloomberg data show.

Investors desperate for high yielding assets are cutting companies more slack and accepting weaker debt terms because central bank stimulus has sent yields on $11.4 trillion of securities below zero. Average yields on junk-rated bonds slumped to a record low in Europe and globally are dropping toward unprecedented levels reached two years ago, according to Bloomberg Barclays bond index data.

“Issuers have the upper hand today,” said Rick Rieder, global chief investment officer of fixed income at BlackRock Inc., which oversees $4.6 trillion assets. “You’re seeing lower covenants and more PIK issuance come to the market. I think you have to be thoughtful about where you take risk and how you take risk.”

Average yields on junk debt in euros dropped to a low of 3.76 percent in Europe, down from 5.17 percent at the start of the year, according to Bloomberg Barclays indexes. Globally, speculative-grade debt yields 5.79 percent, down from 8.12 percent at the start of the year. Equivalent debt in U.S. dollars yields 6.16 percent from 8.74 percent at the beginning of 2016.

PIK debt is often issued at the holding company level, which makes the notes riskier because they are one step removed from the operating company. Schaeffler is selling its notes through its holding company.

The debt became popular before the financial crisis because private equity firms used it to fund their take-over deals without the need to use up cash for coupons. More recently, it has been increasingly used in restructurings to take pressure off companies’ cashflows.

Shenzhen, China-based developer Kaisa Group Holdings Ltd. issued about $3 billion of PIKs in July after it completed the restructuring of its offshore bonds and loans. In May, Apollo Global Management agreed to swap $174 million of bonds of Claire’s Stores Inc. into PIKs to give the business time to recover.

‘The End’

“If a company really feels like it’s important to them to pay up to have that feature, you have to wonder as a bondholder if they’re really worried that they’re going to run out of cash someday,” said Mike Collins, a portfolio manager at Prudential Fixed Income, which oversees $652 billion. “When they start PIKing these things, it’s generally the beginning of the end.”

Issuance of PIK bonds, which typically pay more than regular junk debt, isn’t always a sign of distress.

Moody’s Investors Service gave a provisional rating of Ba1, one level below investment grade, to Schaeffler’s new notes on Wednesday.

“The PIK is used as a safety buffer by the company,” said Ilana Elbim, credit analyst at Hermes Investment Management in London, which manages 26 billion pounds ($35 billion). “While the company earned investors’ trust from having this flexibility in the past, it will still need to pay for having the flexibility again today.”

Sub 3%

Schaeffler is selling five-, seven- and 10-year debt denominated in euros and dollars, according to a person familiar with the matter, who isn’t authorized to speak about and asked not to be identified. The five-year euro notes are being marketed to yield between 2.75 percent and 3 percent, compared with 4.125 percent for the five-year dollar bonds, the person said.

Ardagh refinanced its existing PIKs at cheaper rates on Wednesday and added 270 million euros of the debt to pay a dividend to its shareholders, Moody’s wrote in a report. The ratings company ranked the bonds Caa2, eight levels below investment-grade. The payout is “evidence of a persistent aggressive financial policy,” according to the report.

“The market is extremely strong, yields are low, but so far high yield new issuance has been lower than people expected,” said Felipe Villarroel, a London-based money manager at TwentyFour Asset Management, which oversees 7.3 billion pounds. “It’s not surprising to see a lot of interest from investors in Ardagh and Schaeffler.”

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