A growing number of borrowers are turning to payment-in-kind (PIK) for added interest payment flexibility amid the elevated interest rate environment. Using PIK allows a borrower to make interest payments in a form other than cash (Figure 5). Most commonly this is achieved by accruing—or adding to—payments owed to the total debt. Signs that more borrowers are using PIK to meet their loan obligations are often interpreted as an indication of market stress and therefore increased risk for lenders. However, the story is more nuanced. It is critical to understand not just whether a borrower has turned to PIK but why they have done so, and whether the underlying business is still sound. For example, some borrowers use PIK from the point of loan origination when they are first pursuing financing for their operations and the underlying business model is nonetheless healthy. Others turn to it as an amendment to the agreement during the life of the loan in times of stress or when they can’t afford interest payments anymore. Even in the latter instance, they may be able to resume payments in the future, and in many cases it can be worth taking the risk that they will do so.

At the core of all investing is balancing risk and opportunity, and this is certainly the case with PIK. For example, in some cases, instead of accrued interest, PIK can also take the form of equity or preferred shares instead of cash. PIK helps a business facing liquidity issues to preserve cash, but it leads to higher interest assessments added to the principal. When PIK takes the form of equity, it can dilute shareholder equity. The risk for lenders is that the accrued interest is never received. On the other hand, the upside for lenders is that PIK increases the yield on a loan, potentially boosting returns. While some PIK is generally not considered to be a major concern, it can add to the potential riskiness of the loan by increasing the debt load. As such, it remains a trend worth monitoring because it can be one indicator of potential portfolio issues ahead.

S&P Global Rating predicts that the use of PIK will rise this year and into 2025 as companies struggle to keep their debt obligations current amid high rates. Driving the increasing use of PIK is the large amount of debt, both public and private, that will need to be refinanced in the next few years. However, some borrowers may struggle to find financing via syndicated bank loans. That is because bank loans are mostly sold into collateralized loan obligations (CLOs). Generally, CLOs can only buy 5% or less of their assets in PIK facilities and cannot buy any assets that are currently paying PIK interest. As borrowing has become more expensive and bank lending has slowed, CLO issuance has declined, too.

All of this is expected to contribute to a growing number of borrowers looking to private credit solutions for financing. For investors, the increasing incidence of PIK is perhaps more than anything a reminder of the importance of working with a private credit manager with a proven track record of navigating economic cycles and being prudent about how and when to use a feature such as PIK in a portfolio.