What is PIK Interest?

//What is PIK Interest?
What is PIK Interest? 2017-10-09T05:30:43+00:00

Definition: Payment in kind (PIK) interest is the payment of a good or service in place of cash to settle a debt. This is common in the financial industry when companies pay shareholders and bondholders their interest or dividend payments in additional shares or bonds instead of cash.

What Does PIK Interest Mean?

What is the definition of payment in kind? PIK can be an interest-paying financial instrument, such as a bonddividend or stock, but it cannot be cash in hand. Although it seems straightforward, PIK is a perplexed topic in leveraged finance because the notion of interest relates to the interest that is paid by a borrower to a lender in cash.

However, PIK is an attractive way for companies to avoid cash outflows for debt interest, especially when participating in a leveraged buyout (LBO) or when seeking to expand the business. Therefore, PIK describes the interest paid in a deferred way via the issuance of securities.

Let’s look at an example.

Example

Alexandra owns a bond from the company ABC. The bond has a face value of $5,000, pays a coupon of 10%, and has a maturity of 10 years. So, Alexandra would normally get $500 as an annual interest at the end of the first year. However, the corporation decides to compensate all bondholders in payment in kind, and instead of a bond being paid in cash, it pays the bondholders with mode bonds.

At the end of the first year, the corporation has increased its debt by the number of bonds it has distributed to the bondholders, and the debt will continue to grow until maturity. On the other hand, offering bonds to the bondholders reduces the need to make cash payments on the coupons. Yet, given that the new bonds add up to the existing debt, the corporation needs to leverage debt to avoid liquidity problems.

Sometimes, overleveraged corporations may end being bankrupt. Therefore, PIK bonds, although they lower the cash outflows, they also compromise a percentage of the company’s total debt until maturity.

Summary Definition

Define Payment-in-Kind Interest: PIK means the exchange of goods or services to satisfy a debt instead of using cash.