PIK and spreads

Headline spreads look calm. Underneath, something is cracking.

But first, what is PIK?

PIK means "payment in kind." Instead of paying interest in cash, a borrower adds the interest to the loan balance. The debt grows, and no cash changes hands. Think of paying your credit card bill by putting it on the same credit card.

It can be a legitimate tool for a healthy company in a temporary squeeze. But when a company switches from cash interest to PIK, it's often because it can't afford the cash payment.

Take a look at the bottom chart below. PIK loans in BDC portfolios (the public vehicles that hold private credit) rose from 946 to 1,089 in a year, up 15%.

🔹 +376 loans switched from cash-pay to PIK

🔹 -194 switched back to cash

🔹 +64 new PIK loans

🔹 -172 PIK loans exited

Conversions outnumbered reversions almost 2 to 1. Stress is being renegotiated rather than recognized. The lender still books the income, and the loan doesn't show up as a default.

Now take a look at the top chart below

Overall US high yield spreads sit near 300bp, close to historic tights. On the surface, credit looks healthy.

But look at the ratio of CCC spreads (the weakest borrowers) to overall high yield spreads. It has surged to roughly 3.4x, the highest in this 30-year chart. That's higher than 2008 and 2020.

Investors are paying up to own the strongest credits and demanding a steep premium for the weakest. The market is splitting in two.

Public markets are pricing in dispersion: strong credits are fine, weak ones are in real trouble. Private credit is showing the same pattern in a different form. The weak borrowers are using PIK, amendments, and extensions to avoid a default that the public market would price immediately.

Private marks update slowly and don't have a daily screen price. So the stress may surface later, through NAV marks, dividend coverage, and non-accruals.

What to watch next

• Do PIK loans revert to cash, or stay PIK?

• Do private marks converge toward public CCC pricing?

• Does dividend coverage at BDCs hold up as more income is non-cash?

• Does the CCC premium keep widening while headline spreads stay tight?

  
  

Tight headline spreads don't mean there's no stress. They may just mean it's concentrated in the weakest corner of the market, where it's easiest to ignore.

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