The term payment-in-kind bond refers to a security that provides the issuer with the option of paying the holder with additional bonds rather than cash. Payment-in-kind bonds are oftentimes issued by corporations experiencing financial distress.
Bonds are frequently purchased by investors that are seeking a reliable source of monthly or quarterly income. Also known as a PIK bond, a payment-in-kind bond provides the issuer with the option of paying the bondholder with additional bonds rather than cash. This mechanism is similar to the behavior of zero coupon bonds. For this reason, investors looking for a reliable source of income should not purchase PIK bonds.
Unlike zero coupon bonds, issuers of payment-in-kind securities are typically financially distressed. The additional risk of non-payment translates into relatively high rates of interest paid on these bonds. Holders of these securities are usually hedge funds, which can use a variety of derivatives to counteract the risk of non-payment or default.