* Risky PIK toggles fly in low-volume market
* Investors bank on IPOs providing exits
* Others fear fundamentals overlooked on some deals
By Natalie Harrison and Robert Smith
NEW YORK/LONDON, Nov 8 (IFR) - Investors' search for juicier coupons has fuelled a surge in payment-in-kind toggles over the past few weeks, but their thirst for yield may in some cases be clouding their judgement.
Last week saw almost USD1bn of supply in the US from just two issuers - retailer J. Crew and healthcare company Capsugel - while PIK toggle volumes in European currencies have gone from zero to EUR3.5bn-equivalent in just nine months.
The Federal Reserve's decision in September not to scale back its bond-buying program has fuelled demand for riskier structures, fostering a belief in the credit market that everything is bulletproof.
"Everyone was worried about tapering in September, and issuers rushed to the market," said New York-based Kete Cockrell, head of high yield capital markets at RBC. "But when tapering didn't happen, investors began to feel more optimistic, and seem to think it will be smooth sailing into the year end."
PIK toggles are a variation on PIK notes, which allow borrowers to let interest on the principal accrue if they do not have sufficient cash to make a regular coupon payment.
Their deep subordination typically means they offer very attractive yields - and at a time when high-yield bond supply has tapered off, investors are finding those yields too tempting to turn down.
Global high-yield volume fell to USD41.9bn in October from a record USD65bn in September, and it is running at just USD7.5bn so far this month, according to Thomson Reuters/SDC data.
"We have seen reverse inquiry from investors highlighting that, in credits they like, they want higher-yielding paper from that issuer," said A.J. Murphy, co-head of global leveraged finance at Bank of America Merrill Lynch in New York.
RENT A PIK
One banker described PIK toggles as "rentals" - a vehicle that sponsors use to fast-forward the proceeds from an targeted IPO. And with the exception of the PIK toggle issued by retailer Neiman Marcus in October, structures have all been at the holdco level to fund those dividends.
Companies like Capsugel, bought from Pfizer from KKR in 2011, have also deleveraged - a factor that makes investors more comfortable that an exit, such as an IPO, is more feasible to repay the notes.
And if they bet right, the returns can be huge.
Burlington Coat Factory, taken private by Bain in 2006, will use the proceeds from its IPO to repay its 9% PIK notes maturing in 2018 when they become callable in February, just as Belgium-based Taminco did after listing in April this year.
Schroders made a total return on the Burlington PIK in excess of 10%, after holding the bonds for eight months through to mid-October. That far surpassed the 3.97% total return of the firm's ISF global high-yield fund over the same period.
And PIKs may even be a good asset to own in a rising rate environment.
"If you are looking at interest-rate risk across your portfolio and a very tight new-issue market, you may want to buy a holdco PIK toggle deal a few hundred (basis points) back...rather than to keep putting on double B names at 4.5% or 5%," said BofA's Murphy.
Less investor friendly provisions on some of the recent new issues, though, are making some investors think twice about the relative risks and rewards.
KKR, for example, has the option to buy back up to 100% of the Capsugel PIKs at 102 over the next year, and at an even lower price of 101 between November 2014 and November 2015.
For investors hoping to clip the 7% coupon - either in cash or in kind - for as long as possible, the bond's upside is capped.
"When you have short call protection, you are really buying asymmetric risk because the upside is limited, and it's really more akin to buying the bridge risk from a sponsor," said one high-yield investor.
"The downside, on the other hand, is unlimited, especially if the economy deteriorates."
As discipline weakens on key points, some investors have even questioned whether some deals should have priced at all. One deal announced this week for Albea Beauty, initially expected to price on Wednesday, had not crossed the line by late Friday.
As a holdco instrument, PIK toggles rely on dividend streams from the opco to pay cash. However, there have been recent examples of deals where restrictions on those payments means there is not enough cash to service the debt.
Spanish issuer Befesa, for example, priced a EUR150m PIK toggle last month, despite the issuer's EUR6m restricted payment basket covering barely more than a third of the PIK's EUR15.75m annual coupon.
Another investor said it was "stunning" the deal even got done.
HEDGING RISK IN A HOT MARKET
In light of these potential pitfalls, credit analysis on these deals is especially important for investors. Cashflows need to be high enough to service the debt, and leverage should be moderate for an IPO to be feasible, the first investor said.
High leverage is not a barrier to doing deals, however, as long as deleveraging is credible. The AA's sterling PIK toggle took leverage to a whopping 8.1x. Yet investors bought it at 9.5%, as the firm expects to delever to below 6.5x in 18-months.
For sponsor-backed businesses that are not yet ready for an IPO exit, dividend holdco PIKs are the ideal solution. Thus, there still seems plenty of scope for more supply.
"The IPO market is clearly hot, but for companies where a listing is some months out, I think some sponsors may ask, why take a gamble?" said Murphy.
"They may as well hedge some of that risk by taking some money off the table now from a dividend PIK."