John Dizard: The yield-hungry jostle for a PIK

A thousand years ago the faithful few looking for portents of the End of Days would nervously exchange stories of the birth of two headed calves, comets and speaking icons. In the financial markets today the faithful are exchanging portents of the End of Cycle, including, recently, a €325m ($419m) "callable PIK" issue for Jefferson Smurfit, the privately owned Irish packaging company.

While not very big, the two or three callable PIK (payment in kind) issues carried out in the Euromarkets over the past couple of months are now considered to be the final, definitive proof that this is the top of the market for credit.

A callable PIK is a bond that does not pay interest in cash but instead spawns coupons in the form of new mini-bonds, as it were. At maturity, the principal and interest PIK payments are paid out in cash (probably raised from yet another issue). In the meantime, the "bond" is way down the seniority chain, really a sort of quasi equity. The callable feature means the bond can be redeemed, typically at a premium, before the final maturity.

PIKs have been around for a fairly long time but the catch used to be that they paid a high interest rate on maturity and they could only be redeemed early at a crushing premium. If the speculative investor was going to buy these paper towels then it was necessary to have usurious rates locked in for a long time. For example, the last time Jefferson Smurfit issued PIKs, back at the time of its going private in 2002, the PIKs were issued to yield 15.5 per cent and were only callable at a price of 108 in October of 2005. The new Jefferson Smurfit 10-year PIK issue carried out in mid-January, which pays out at 11.5 per cent annually, can, however, be redeemed in two years at a price of 102, then 101, and can finally be called at par in January of 2009.

Jefferson Smurfit's banks had no objection to the PIK issue - after all, it didn't increase the cash expenses of the company. The purpose of the issue, by the way, was to shrink the equity base of the highly leveraged company even further. The original investors in the leveraged buyout are taking back €325m out of €732m. Since the PIKs are a sort of Monopoly money debt, who cares?

Jefferson Smurfit's management has a broad fiduciary responsibility to its shareholders, and shareholder interests were well served by the deal. It is an established principle of law that bondholders' rights are restricted to what is spelled out in the offering documents. If the documents contain unfavourable terms, that is the bondholders' problem.

I wondered why someone would buy this paper, so I asked Ian Curley, the CFO of Jefferson Smurfit, if the purchasers were over the age of 21 and of sound mind. He said that to the best of his knowledge they were, and that they were all qualified investors. While I was trying to absorb the last point, he elaborated on the economic justification for the deal.

"Equity capital is the most expensive," he said, "so you can assume that the cost of that part of the capital structure, coming from buyout funds, would be about 20 per cent annually. We are replacing that with 11.5 per cent paper."

The key is the relative stability of the cash flows, which are in the €600m range, and which lately have fluctuated by less than 10 per cent a year.

"We couldn't believe that we sold the Smurfit deal," says one of their bankers. In fact, far from having to push this paper on reluctant customers, there was apparently €700m to €800m of bids chasing the €325m deal (which was originally to have been €300m). Mr Curley says the deal represents "logical opportunism", adding, "you have to jump through these windows quickly before they close".

This shows how desperate the yield hunger has become.

Not only are the investors subordinated to the banks' cats and dogs but they are only promised their slightly double-digit yield for two years.

They are taking what was the equity risk slice of the capital structure a month ago and are getting just a little over half the return for doing so.

A couple of weeks ago I had a chat with a big developer in Miami, one who has survived and prospered through the notoriously cyclical Florida housing market.

"I am paying off the banks, paying off my partners and taking it easy," he said. "This isn't the time to take a risk. If people want to buy my units, fine. If not, I can afford to pay for the maintenance."

"That's easy for him to say, or for me to say," responded a veteran bond dealer. "It's his own money, and for us, it's my money and my partners' money. But the portfolio managers are chained to the Lehman index [of bonds, which many managers' performance is measured against]. They can't pull back just because there's no value left in the credit market - and there isn't."

And that explains Jefferson Smurfit's callable PIKs.