Toggle bonds are a sign of the times. Desperate for yield in a market in which even junk bonds are selling for historically low premiums over investment-grade debt, creative investment bankers have come up with the toggle bond. For advisors and their clients, they offer handsome yields with high risks.

Toggles are bonds that may pay cash or, at the preference of the issuer, can be switched or “toggled” to pay IOUs in the form of yet more bonds. The obvious question: why anyone would buy a bond from a company that might be unable to come up with cash for the coupon?

So far, bond buyers hungry for yield are not worried. And they have been handsomely rewarded for their faith. For example, PNA Intermediate Holding Corp. sold a bond that is due February 2013 with a yield of 12.365%, which was about 700 basis points more than a U.S. treasury bond at the time of issue in February 2007.

The appeal of toggles is their yield boost: at least 75 bps if the coupon is paid in bonds over what would be the cash coupon, and sometimes a great deal more. If paid in cash, toggles resemble the “pay in kind” (PIK) bonds used by developer Robert Campeau of Ottawa in his 1988 takeover of the Allied and Federated Department stores in the U.S. Campeau and investment dealer First Boston used US$250 million of what was, in essence, the crummiest of junk debt to acquire Bloomingdale’s, Brooks Brothers, Ann Taylor and Jordan Marsh, as well as a few less prestigious names such as Herpolsheimer’s, a store in Grand Rapids, Mich., known as “Herps” by locals. By 1990, the Campeau caper was over; Allied and Federated were insolvent.

Today, PIKs are being repackaged as toggles. Toggles are not very different from a strip bond that postpones interest to the end of its life, or a stock that pays no dividends but that may, if its issuer grows and prospers, one day institute a handsome payout. Tarted up as a toggle bond, the PIK becomes a hybrid instrument for which the issuer pays a premium to postpone cash payments and, instead, issue more bonds.

Canada is not foreign territory when it comes to bonds that pay bonds rather than cash. In 2000, CanWest Global Communications Corp. issued PIKs to pay for the acquisition of Hollinger International Inc.’s newspapers. The notes carried a 12% interest rate and were dead weight for the Winnipeg-based publisher until they were refinanced.

To date, none of the toggle notes tracked by Barclays Capital has had to switch from cash to junk paper. The question, therefore, is whether toggle holders are being adequately paid for the risk that they may have assumed to take IOUs for cash.

So far, toggle holders are well paid. The US$4.1-billion Nieman Marcus toggle of September 2005, which pays 9% until October 2015, carries a relatively respectable B- rating and was sold by Goldman Sachs Asset Management, among other high-profile dealers.

And Univision Communications Inc., a Los An-geles-based company that broadcasts to the Hispanic community, financed an expansion with US$1.5 billion of toggle bonds on March 1, rated CCC+ by Standard & Poor’s Corp. The bonds pay 9.75% interest with a 75-bps boost if PIK coupons are issued instead of cash.

If these bonds continue to pay cash, their holders will be immensely enriched with what amounts to a good stock return.

But the bonds’ ratings suggest otherwise. As Chris Kresic, senior vice president of investments at Mackenzie Financial Corp. in Toronto, notes, half the bonds with CCC ratings default within five years. “With the risk you are taking, why not just buy the stock?” he asks.

Keeping a good name should persuade most toggle issuers to avoid a decision to issue bonds in lieu of cash. In other words, if a company decides it can’t afford to pay cash, the next bond issue it tries to peddle would either fail to sell or be sold at a huge discount.

Tactically, your client should be able to make a profit if an issuer’s total toggle debt is small and the issuer would be reluctant to switch to the PIK option and issue yet more high-yield debt.

@page_break@“We believe such issuers with significant amounts of this debt are more likely to toggle to PIKs when it is economically advantageous to do so,” Barclays suggests. Translation: why risk your reputation even as a speculative credit when there is not much money to be saved and much to be lost in future?

The acid test will arrive when the toggles come due. The issuer must then pay cash for the principal and all coupons issued in lieu of cash, says Sol Samson, managing director for corporate ratings at S&P in New York.

Stay tuned. IE