Covered Bonds
February 12, 2025
There are several cognitive biases that affect our ability to think clearly about financial investments. One such bias is called the hindsight bias. Over the years, the effect of hindsight bias on the value of investor portfolios has been significant. This is the reason that we will have a closer look at what this bias […]
Proponents of the free market generally believe that competition is good for the economy. They argue in favor of the competition every time. Hence, it is natural for them to feel that competition in taxes is also good. The general argument is that competition forces the governments to rationalize and become more efficient. However, there […]
In the previous article, we had a closer look at the concept of covenants as well as indentures. However, we only covered the basics. Indentures and covenants are extremely important to the investors who deploy their money in fixed-income securities. It is for this reason that investors need to have a better understanding of the […]
Free cash flow models can be further categorized into two types. There are certain kinds of models which pertain to free cash flow that the firm as a whole will generate whereas there are others that pertain solely to the perspective of equity shareholders. These models are quite different from each other. It is therefore […]
The Indian banking sector is facing a crisis on an unprecedented scale. The problem becomes peculiar when more facts are brought to light. Indian banking sector can be divided into two categories. There are private sector banks, and there are public sector banks. The private sector banks seem to be performing well. However, public sector […]
In the past few articles, we have studied about different types of coupon payments. These coupon payments vary from each other a great deal. However, they all have one thing in common which is the fact that the interest is always paid in cash. However, payment in cash need not always be the case. There are certain special types of bonds in which borrowing companies have the option to pay the interest in kind. This is the reason that they are called “payment in kind” bonds. In this article, we will have a closer look at the various types of payment in kind bonds as well as their advantages and disadvantages.
Payment in kind bonds are bonds that provide the borrowing company with the flexibility of making interest payments by issuing more securities. This means that whenever the interest payment on the debt issue comes due, the company does not have to liquidate its cash. Instead, it can simply issue more securities in order to offset the accrued interest.
It needs to be understood that only periodic interest payments can be made in kind i.e. in the form of securities. However, when the actual principal becomes due, that has to be paid for in cash. This means that borrowing companies can issue additional securities in the interim. However, finally, they have to pay cash on maturity. The borrowing company can choose between bonds, preferred debt, and notes in order to make interest payments. However, most often the security chose to make such payment bonds themselves. Payment in kind bonds are issued by companies who do not want to have immediate pressure on their cash flow.
Payment in kind bonds provide both investors as well as borrowing companies with some significant advantages. Some of these advantages have been mentioned below:
Payment in kind bonds are considered to be very risky. This is because they have some obvious disadvantages over other categories of bonds. Some of these disadvantages have been listed below:
As we can see from the points mentioned above, the disadvantages of payment in kind bonds vastly outnumber the advantages of such bonds. Hence, it can be said that these bonds are considered useful by a very specific clientele.
Firstly, it is important to understand that not all payment in kind bonds is the same. There are multiple variations of the payment in kind bond. Let’s have a look at these variations below:
Payment in kind bonds can often lead to more advantageous outcomes for the investors holding the bonds. This is largely because of the fact that in most parts of the world capital gains taxes are charged at a lower rate as compared to income tax. When investors receive regular income in the form of a coupon payment, it is taxed at a higher rate. However, when the same investor receives additional bonds in lieu of interest and they earn money by selling those bonds, then the income so generated is considered to be capital gains and is taxed at a lower rate.
The issuing of payment in kind bonds by certain organizations may be considered to be dangerous. This is particularly true if the total debt of these organizations is hovering around the maximum debt which is allowed by covenants of their other bonds. In such cases, they may not be able to issue more bonds in lieu of interest since if they do so, then they will exceed the upper cap on leverage.
Payment in kind bonds can be advantageous for the issuing firm also. This is because accounting works on the principle of accrual. This means that the interest is recognized when it becomes due. The fact that interest is not paid out immediately is irrelevant to the calculation. Hence, as soon as the interest gets accrued, it is recognized as debt on the balance sheet. This also means that the expenses go up by that amount. As a result, the company pays a lower tax.
Hence, it can be said that payment in kind bonds provide a tax shield to the company. Since debt is used to lower the tax at the accrual stage, it may not be available to lower the tax when it is actually paid out. However, this is not important since because of the time value of money, the company ends up in a more advantageous position by saving the tax upfront.
However, payment in kind bonds often lead to balance sheets becoming bloated. This is because of the fact that the accrued interest immediately increases the liability of the company. The cash is only increased by the amount of tax saved. The balance amount results in a deduction to equity. Hence, payment in kind debt has an immediate negative effect on the net worth of the organization.
The bottom line is that payment in kind debt has many variations and each variation has its own set of advantages. Also, the taxation and accounting treatment of these bonds is different given the different nature of these bonds.
Your email address will not be published. Required fields are marked *