NEW YORK (Reuters) - More companies could choose to sell additional junk bonds rather than pay interest to investors as they try to conserve cash in a weakening economy.

Traders work on the floor of the New York Stock Exchange March 17, 2008. REUTERS/Brendan McDermid

Along with drawing down revolving lines of credit and exchanging old debt for new, this is another sign that some firms are experiencing financial distress in the current economic environment, analysts said.

The option to pay interest with debt is available to companies that sold pay-in-kind (PIK) toggle bonds when bondholders were lending money to junk companies on easier terms before the credit crunch hit.

The structure provides a lifeline to distressed firms, allowing them to preserve cash and likely avoid defaults, but bondholders are now exposed to potential losses.

“We are going to have a problem over the next couple of years because of the history of these toggle bonds that have been sold in the high yield market,” said John Atkins, credit analyst at research firm IDEAglobal in New York.

“Instead of paying cash on the interest, you just issue more bonds. The debt becomes worth incrementally less over time if they continue to dump more bonds into the pool,” he added.

The number of companies that are using this option is on the rise. Out of 43 bond deals that have a PIK feature totaling $23.5 billion, eight have paid interest with debt or announced plans to do so, according to Standard & Poor’s Leveraged Commentary and Data.

The latest announcement came last week from silicone producer Momentive Performance Materials, which said it would pay interest on $300 million of its 10.125 percent notes due on December 1 with more debt.

Momentive was the third company owned by billionaire investor Leon Black’s private equity firm Apollo Management that chose to exercise its PIK option.

The other two were real estate and relocation services provider Realogy Corporation and jewelry retailer Claire’s Stores.

Harrah’s Entertainment, the world’s largest casino operator and another Apollo Management sponsored issuer, has until August 1 to make a decision on exercising the PIK option, Lehman Brothers said in a research note.

This trend “has a potential to lead to large price movements in cases where the decision to exercise the option comes as a surprise,” Lehman Brothers said.

For example, Momentive’s 10.125 percent notes due in 2014 dropped to 86.5 cents on the dollar on May 28 when the announcement was made from 93.375 cents on the dollar on May 20, according to MarketAxess. The yield surged to 13.29 percent from 11.6 percent.

This bond structure was popular with leveraged buyouts which proliferated before the credit crunch hit in the middle of summer 2007.

Private equity firms were active in the leisure businesses such as hotels, gaming and restaurants. Profits in this industry and other cyclical sectors are getting squeezed as food and oil prices soar and consumers spend less on travel and entertainment while they fear the slower economy will cost them jobs.

"The fact that issuers are taking that option to make interest payments with further debt indicates that they are suffering some financial distress," said Kenneth Emery, senior vice president at Moody's Investors Service MCO.N in New York.

Corporate America’s credit quality is sinking at a record pace as the subprime housing crisis takes a toll.

Credit rating downgrades and warnings by Moody’s are on pace to hit a record $1.6 trillion in the second quarter, topping the massive credit deterioration seen in the bankruptcy wave of 2001. For details click on <ID:nN05381721>.

Standard & Poor's, a unit of McGraw-Hill MHP.N, said the number of companies around the world at risk of a credit downgrade climbed to a record in May. <ID:nL06911075>.

These rates could have been even higher if weak companies could not sell more debt rather than pay out interest.

Some companies choose this PIK option because they can use cash meant for the interest payment to buy back outstanding debt in the secondary market, which could reduce the total debt burden.

“It’s really affecting the default rate,” said Mirko Mikelic, senior fixed income analyst at Fifth Third Asset Management in Grand Rapids, Michigan. “It’s given firms a lot more leeway.”