High-yield bond issuers are increasingly embracing a newfangled security in their quest for capital: "pay-in-kind" preferred stock.
Issuance of these securities, which are issued as stock and can be converted to debt, has swelled dramatically this year and is on track to break last year's record pace.
So-called Pik preferreds allow high-growth companies with hefty short- term cash needs to raise the capital needed to expand their operations without violating debt covenants.
"Pik preferreds are clearly a legitimized asset class," said Derrick Herndon, head of high-yield sales and trading at TD Securities, "and it makes sense for fast-growing businesses. It allows them to raise junior capital today for expansion, without diluting their equity value."
So far this year $1.46 billion of public and private exchangeable preferred stock has been issued, according to Securities Data Co. Last year issuance reached a record $1.86 billion.
Media, cable, and telecommunications companies, which make up about 30% of the high-yield market, are the most frequent issuers of the securities.
Not surprisingly, the largest underwriters of these instruments are commercial and investment banks with long-standing relationships with media companies, including Bankers Trust New York Corp., CS First Boston, Canadian Imperial Bank of Commerce, and Donaldson Lufkin & Jenrette Inc.
Pik preferreds are particularly relevant for the rapidly growing media and competitive local exchange carriers (CLEC) businesses that are expanding their operations through acquisition or development. Pik issuers and investors say these companies will be able to turn cash flow positive in a couple of years, Mr. Herndon said.
Phelps Hoyt, an analyst with KDP Investment Advisors, a Montpelier, Vt., firm that tracks high-yield bonds, said, "If there's a delay in cash flow from the acquisition, it can give them the flexibility to expand, more so than if straight debt was issued."
Investors say that spreads on these securities are about 150 basis points wider than on traditional high-yield bond issues, but that they are continuing to tighten. Underwriting fees tend to be 3.25% to 3.5%, slightly higher than on straight high-yield bond issues.
One recent issuer of Pik-preferred securities is SFX Broadcasting Inc., the New York-based radio company recently acquired by buyout firm Hicks, Muse, Tate & Furst. As SFX closed an acquisition last year, it had already started eyeing its next target. With that in mind, the company issued $225 million of Pik-preferred securities earlier this year through BT Securities Inc.
"On the plus side, the securities are a cash saver to the corporation. They are also another layer of quasi equity that it can use to leverage off of, and take advantage of, other opportunities," said SFX's Timothy Klahs, director of investor relations.
"On the down side, the market understands its level in the capital structure and charges an appropriate premium."
Investor Harry Resis, who manages about $5 billion of high-yield assets for Kemper High Yield Fund in Chicago, acknowledged that the securities have been outstanding performers that provide good total returns in the short run, but they do have disadvantages.
"In the long run, since they're junior to debt in the capital structure, if the company runs into trouble, the bonds will drop harder and be more difficult to sell," Mr. Resis said. "But in the short run, though, it makes sense for the companies."