COVID-19 and deferred interest payment solutions

Introduction

COVID-19 is the black swan event of our era. It has taken lenders and borrowers by surprise. The impact of lockdown on cashflows across most sectors has been dramatic and like nothing seen in a generation. The reaction of borrowers has been on protecting employees, understanding the risks to their businesses and managing the customers and supply chain disruption caused by the pandemic. The impact on borrowings, cashflows and the need for restructuring of bank facilities is now becoming a priority as borrowers engage with their lenders to seek solutions.

One solution that has become increasingly popular between lenders and borrowers is the management of interest payment – either by allowing deferral of interest or converting interests to payment in kind (PIK).

Deferral of interest

Deferral of interest refers to the suspension of interest payments for a certain period of time (often called a payment holiday) as agreed between a lender and a borrower. During the deferral period, interests will continue to accrue on the outstanding principal and the accrued interests will become due and payable upon the expiry of the deferral period or can be spread over the remainder of the loan.

Benefits and risks

Deferral of interest is particularly helpful to borrowers who are enduring financial hardship by delaying their payment obligations and therefore avoiding the occurrence of an event of default. However, if a borrower is unable to improve its financial condition, the obligation to pay the aggregate of all deferred interests and outstanding principal amount at the end of the deferral period would result in an even more onerous burden on such borrower. The deferral of interest would also increase the lender’s exposure to credit risk and the fact that a growing number of borrowers are showing their inability and unwillingness to pay interest on time poses a greater credit risk more generally.

Market trend

In light of the COVID-19 pandemic, interest deferral provides a solution to lenders who are willing to offer borrowers flexibility in interest payment rather than calling payment defaults. At a governmental level, central authorities across the globe have been cooperating with financial institutions to launch financial support packages to corporations in financial hardship and these measures include interest deferral schemes.

Payments in kind

Another solution is the use of PIK clauses. Traditionally PIK loans have been used in leveraged transactions which allows interests to be paid in kind or in the form of additional securities instead of cash, or extra debt securities may be issued to settle interest payment obligations. PIK clauses are now also used to deal with financially distressed borrowers.

The three major types of PIKs are:

• True PIKs: the interest is capitalized and added to the principal amount of the loan (to be compounded at each interest period) and often repaid at maturity or spread over the life of the loan;

• PIK toggles (also known as “pay if you want” PIK): The borrowers can, at their sole discretion, elect to pay the interest in kind, in cash or a mixture of both, taking into account their financial situations; and

• Contingent PIK toggles (also known as “pay if you can” PIK): The borrowers are required to pay interest in cash only under certain specified conditions – typically include the breach of financial covenants. Otherwise, the borrowers are entitled to pay interest in kind, although likely at an elevated interest rate compared to payment in cash.

Benefits and risks

The flexibility of PIK relieves the borrowers from the burden of repaying interest in cash while choosing to capitalize the interests or issue further securities to satisfy their interest payment obligations at their liberty. With the growing number of financially distressed corporations during the COVID-19 pandemic, PIK also allows them to leverage up while conserving cash for their operation and improve liquidity.

It is worth noting that as a compromise to the greater risk that the lenders bear (such as the inability to receive cash interest payments until the loan maturity date), lenders normally charge a higher interest rate for PIK loans.

Conclusion

The outbreak of COVID-19 has brought unprecedented challenges to all businesses with no one knowing exactly when the pandemic will be over. It is likely that we will see more payment holidays and other solutions to help borrowers tackle their cashflow issues during these difficult times.