Toggle notes have established themselves as a fixture of the European capital markets, a development confirmed by news that a tranche of toggle notes (also known as payment in kind election notes) will make up a portion of the €310m of new senior notes being issued by Ardagh Glass through lead manager Citi and co-manager Credit Suisse.
The Ardagh Glass deal is the second use of toggle bonds by a European issuer, following a €640m deal from Countrywide in April that included a €100m senior secured tranche of toggle notes.
The toggle instrument works by giving the issuer the discretion either to pay interest in cash or opt to convert cash-pay notes into PIK notes with the interest accrued added as new debt securities. There is generally a third 50:50 cash pay/defer option.
The option to PIK usually lasts for the first half of the life of an instrument. It can be used on fixed and floating-rate notes and across any level of seniority, though it tends to be used on senior, lower volatility and lower leverage pieces.
As with other instruments that cut the cost of regular debt servicing, this ability to free up cash earmarked for amortisation is especially attractive in cyclical industries.
“But while not itself credit-negative, the toggle can be a cause for concern,” said Michelle DiAngelis, senior director of leveraged finance at Fitch.
“The instrument gives additional financial flexibility to the issuer, which is a credit positive, but in the case of weaker issuers the need to have the toggle option might result from lower resilience of a given credit to withstand a downturn, or could reflect a greater risk of volatility or cyclicality in its market,” she said.
For investors, DiAngelis noted that, unlike some other trends in leveraged finance, the toggle incentivises both issuer and lender, saying: “The leveraged finance market today is a borrower’s market, so if the toggle bond does offer additional reward to investors for taking additional risk, in that context it’s probably quite attractive.”
Mathew Cestar, head of European high-yield at Credit Suisse, attempted to quantify that extra reward.
“On a new issue, the toggle comes with a 25bp–50bp richer yield than the non-toggle tranche, and in the event that it does toggle to PIK, includes a further step-up, which is fairly standard at 75bp,” he said. “In total, that amounts to a 100bp–125bp deferred pay spread – bringing the issue into line with other deferred pay instruments.”
Added yield, coupled with low defaults and a benign macroeconomic climate, have so far been enough to ease any concerns that the toggle is another sign of stretched leverage.
“On Countrywide, the toggle and non-toggle pieces were equally oversubscribed,” said Cestar.
But what is so far untested is what happens when an issuer does eventually use a toggle.
Cestar believes that investors are covered in such an event. “The deferred pay spread should ensure investors are compensated. Electing to defer interest, however, may well be a sign of a problem with the credit itself, with an effect on all of its securities,” he said.
DiAngelis took up the point, saying: “We would generally take the view that actioning a toggle is not in itself a default, though if it is exercised it may indicate that the company is showing signs of stress, a fact that would be reflected in its issuer default rating.”
In the US, investors have had longer to adjust to the instrument and have seen it employed across a number of credits and sectors. Realogy, HCA, Hawker Beechcraft, Univision, Neiman Marcus and US Oncology, among others, have priced toggle notes or loans in the past two years, with the structure becoming common only in late 2006.
Investors view toggle notes as lowering the risk of default because a company could defer some of their interest costs should they run into trouble.
“It prolongs the day and creates less pressure for a bankruptcy, so the default rate is lower,” said Richard Coons, hedge fund manager at Catrock Capital. But when a company does have serious long-term problems, toggle notes extend duration, and credit quality could further deteriorate in that time-frame, leading to lower recovery rates in a bankruptcy.
“We prefer not to own them, but we will pick up a bit of yield in credits where we think the toggle won’t be utilised,” said Al Alaimo, portfolio manager at SMC Advisors in San Francisco. Univision, for example, seems unlikely to toggle its US$1.5bn in 9.75% notes due 2015, he said.
“We don’t think they will ever need to use the toggle because they have enough cashflow to service their debt,” said Alaimo. “It’s a stable, even growing, business.” Those bonds are trading at 103, after being priced at par in early March.
Likewise, HCA is not likely to toggle its US$1.5bn in 9.625% notes.
“In addition to being relatively insulated from economic downturns, HCA preserves little cash when toggling to the PIK [1/33rd of the annual Ebitda],” wrote Michael Anderson, US high-yield strategist at Lehman Brothers, in a research report.
On the other hand, Realogy’s 11% toggle notes due 2014 are more likely to be toggled given the company’s recent LBO and exposure to a declining real estate market.
“Instead of an asset-rich, economically insulated credit, this services company is asset-light and operates in the cyclical housing industry,” wrote Anderson. The toggle notes are also 3.5 times more leveraged than HCA’s and the company expects to be free cashflow-neutral in the near term.
The market’s reaction to a toggled note now remains to be seen.
“Companies are going to toggle at their worst time. But right now, people are scrambling for assets,” said one US trader. “If you are comfortable with the credit, then you want those bonds, but no one has the ability to look around the corner with these things.”