From the Collaborative Bond and Money Market Data Portal
A toggle note is a type of payment-in-kind (PIK) bond that provides issuers with flexibility in managing interest payments. These instruments allow the issuer to decide, on each coupon payment date, whether to pay interest in cash or to defer it to a later date. In contrast, issuers do not have the ability to defer interest payments for vanilla instruments. Most toggle bonds specify a limited period during which the issuer can defer coupon payments, after the ability to defer is lost and cash payments become mandatory (like a vanilla bond).
When a bond’s coupon is deferred, additional debt securities are issued with the same maturity date and coupon rate as the original bond and with a principal equal to the deferred interest. It is often the case that the deferred interest is greater than the cash interest the issuer would pay if they did not defer, due to a payment-in-kind premium (PIK premium) specified in the bond covenant. The additional securities are distributed proportionally to whoever holds the original bonds at the time of the interest payment. The payment-in-kind aspect means that bondholders receive payment in the form of more bonds rather than cash.
The issuance of additional securities in lieu of cash interest payments is purely a bookkeeping transaction- no additional cash inflow is generated for the borrower. From an accounting perspective, the borrow is capitalising the interest (i.e. adding it to the principal), rather than expensing it through a cash payment.
By way of example, suppose a corporate borrower issues a 4yr toggle bond with a 5% annual coupon, an initial principal of GBP100, and a 100bps deferral premium. Suppose the corporate borrower elects to pay cash interest as normal in year 1 and 3 and decides to defer cash interest in year 2. Their outgoing cashflows will be:
Toggle bonds with PIK features are sometimes considered more expensive for issuers in the long run, since the deferred interest itself generates additional interest. However, the toggle provision benefits issuers likely to experience financial or liquidity constraints during the term of the bond, as it allows them to conserve scarce cash whilst not defaulting on their debt obligation.
From the investor’s perspective, toggle notes increase risk, due to the uncertainty surrounding future cash flows and potential delays in interest payments. As a result, investors demand a greater yield, relative to a non-toggleable bond.
