Douglas J. Lucas

And When CDOs PIK

High default rates in the high-yield bond and loan market have caused some mezzanine tranches of collateralized debt obligations to stop paying current interest, and instead to pay in-kind, or PIK. When overcollateralization or interest coverage tests are violated in a CDO, cash flows are diverted from the mezzanine classes to pay down principal on the senior-most class. This article shows that if a bond PIKs, it will not necessarily lose its internal rate of return. In fact, for constant default scenarios, the bond will begin to PIK and lose IRR at roughly the same point. For default scenarios in which near-term default rates are high and decline later (the most likely default scenario), the mezzanine tranches will PIK long before they lose IRR. Given todays high defaults, a fair number of mezzanine tranches are likely to PIK over the next few years. But if defaults return to levels closer to historical averages before too much damage is done, investors will come out whole.