Shenanigans! PIK Bond Edition

As follow on to my recent post on “return free risk” in the high yield market, here is a real gem via the FT:

One of Ireland’s richest entrepreneurs has embraced an aggressive new version of an already esoteric form of junk bond, highlighting the level of risk that debt investors are willing to tolerate as they seek higher yields in hot credit markets.

The $350m “super PIK,” or payment-in-kind bond, raised at the end of last week will pay a dividend to a group of shareholders in Ardagh Group, a one-time small Irish glass bottle maker that has grown in the past two decades into one of the world’s largest metal and glass packaging companies.

PIK refers to bonds or loans that can pay their interest with further debt rather than cash. This means the size of the debt can balloon quickly and leave lenders with steep losses if the underlying company is not able to handle the growing burden.

No, your eyes do not deceive you. The company raised a $350mn bond issue that gives it the option of paying coupons with IOUs instead of cash. So it can pay insiders a dividend.

While Ardagh listed on the New York Stock Exchange last year, 92 per cent of its shares are held privately, with its billionaire founder and chairman Paul Coulson the largest shareholder. It is these private shareholders that are receiving the dividend. “In plain terms, the use of proceeds is essentially providing a ‘margin loan’ to legacy shareholders,” noted analysts at credit research firm CreditSights.

Here is the cap structure, if you are interested in a quick round of Spot The Suckaz:

Ardagh_Cap_Structure
Source: FT

And where exactly did this boondoggle price?

Despite its risky structure, the PIK bond sale drew roughly $2.5bn of orders, said a person close to the deal. This allowed it to ultimately price with a yield of 8.75 per cent, below the 10 per cent initially marketed. An older PIK dollar-denominated deal sold by the company in 2017 currently trades with a yield of 6 per cent.

Yeah, I know, it’s all anecdotal evidence. You can’t time the market or the credit cycle. Blah, blah, blah. Nonetheless, I vaguely recall an old Warren Buffett saw… something about when to be fearful and when to be greedy…

Return Free Risk: A Picture Book

Once upon a time there was an asset class called high yield debt. It consisted of all the lowest quality bonds issued by all the lowest quality companies. Companies like Frontier Communications and Sprint and Valeant Pharmaceuticals.

And yet, because There Is No Alternative but to buy risk assets these days, particularly for Yield-Starved Fixed Income Investors, in aggregate this debt traded at yields well below the historical average.

 

118_HY_Spreads

 

You see, what the Yield Starved Fixed Income Investors had forgotten was that high yield debt returns are (badly) negatively skewed.

 

118_HY_Loss_Potential

 

And so what the Yield Starved Fixed Income Investors had bought was return free risk.

 

118_Spred_Per_Turn_Leverage

 

118_Yield_Per_Turn_Leverage

(Charts from a presentation by Troob Capital Management)