Abstract

Recent years have witnessed a proliferation of new types of debt securities. Amongst these, PIK-Toggle bonds give a borrower the choice between rolling over coupon payments by issuing additional bonds or paying the coupon in cash. Despite their controversial nature, we show that for a firm facing liquidity constraints and the possibility of diversion of cash flows, the optimal contract includes an option to skip coupons and automatically increase leverage. This contract combines active rebalancing of debt with the management of the firm’s cash balance and its dividend policy. The optimal contract is preferable when the firm’s expected cash flows are low relative to the costs of servicing the debt; the firm’s cash flows have temporary low Sharpe ratio; and debt restructuring is costly.

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