Does anyone have experience with valuing a HY bond with a PIK toggle? If I had to speculate, I’d assume that in practice they’d be valued similar to a bond with an embedded option to defer and would be valued using a binomial/lattice model. Please enlighten me. Do these bonds typically include a step up on the interest rate if the issuer elects to toggle the PIK? I’ve seen deals where the issuer has to pay an additional 75 bps in the spread over the reference rate if it elects the PIK toggle and am wondering if this has been industry standard. Thanks!

Yes, that’s the industry standard, they’ll always step up if they choose to PIK How they’re valued depends on the circumstances, but I haven’t used a binomial model since I took L2, I can say that much

While I’m sure you could come up with something that you call a binomial/lattice model to value these things, that wouldn’t be the way I would think about it. When you buy one of these bonds, you are also selling an exchange option (a Margrabe option if you want to sound smart) to exchange a coupon bond for a zero at higher yield. So the key is to value that option, which is just one of those boring canonical problems in finance. The problem is that the value of that option depends mostly on creditish issues not interest rates. If they toggle the PIK it means they are so short on cash (or I suppose that interest rates have risen enormously) that they are willing to borrow the coupon payments at the cost of paying a higher interest rate on the entire loan. Not good. If it was me, I would price that option like a package of bond puts and then use some pretty standard pricing of those - a good reference is Jarrow and Trumbull (some year, Journal of Finance).