Payment in Kind Bonds
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.
What are Payment In-Kind Bonds?
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.
Advantages of Payment in Kind Bonds
Payment in kind bonds provide both investors as well as borrowing companies with some significant advantages. Some of these advantages have been mentioned below:
Disadvantages of Payment in Kind Bonds
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.
Types of Payment in Kind Bonds
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. Lets have a look at these variations below:
Taxation for Payment in Kind Bonds
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.
Payment In Kind Bonds and Leverage
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.
Accounting for Payment In-Kind Bonds
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.
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