When FCCBs turns ugly: Part II

This is the second and last article in our series on Foreign Currency Conversion Bonds (FCCBs) in India.

A FCCB is a special type of convertible bond which companies prefer to issue for raising funds for capital expenditure, as the interest rate on them is much lower than that on a regular "domestic" bond.

In our previous article we outlined the benefits of FCCBs to both the issuer (lower interest rates) as well as the bondholder (fixed coupon rate with upside equity potential). We also highlighted that while FCCBs were originally considered a boon, when the markets went south, they turned out to be a millstone around India Inc.'s neck. Since the Indian stock market is in bad shape, most of the bonds are up for redemption this year - 2012. This has serious implications.

In this second article we will discuss the various alternatives available to companies facing this difficult situation of FCCB redemption in 2012.

The options available to companies confronted with FCCB redemption are:

Restructuring of FCCBs: Restructuring of an FCCB usually means changing the maturity and interest rates, and will provide temporary relief to the issuing company. But, it depends on the acceptance of revised terms by the bondholders.

For example: Tata Steel had FCCBs worth $875 million which were due in 2012, and had a yield-to-maturity of 5.15% The securities were convertible at Rs 733, and had a redemption premium of 23% in case they were not converted. When Tata Steel was faced with redemption, it offered 111 bonds for every 100 bonds previously held. The new FCCBs carried a lower yield-to-maturity of 4.5%, and the new FCCBs will mature in November 2014. The bonds are convertible into shares at Rs 605.53 each, and at a fixed exchange rate of Rs 46.36 to the dollar. This restructuring helped reduce Tata Steel’s interest costs and lowered repayment obligations.

It should be noted that restructuring of FCCBs involving change in the conversion price is not permissible. The prevailing regulations allow an Indian company to buy back FCCBs:

1. from existing foreign currency funds and/ or fresh External Commercial Borrowings (ECB) proceeds at a minimum discount of 8%; and
   
   
2. from internal accruals with RBI approval at a minimum discount ranging from 10 to 20%.
   
   

There is no cap on the quantum of buy back using foreign currency funds, nor fresh ECB. However, a buy back from internal accruals is capped at the range of USD $50-100 m. These Reserve Bank of India (RBI) regulations protect the country from experiencing significant foreign exchange outflows.

Buyback: Buyback of FCCBs at a discount provides the Indian company an opportunity to substantially reduce their debt. Though, it does mean that the bondholder takes a hit on their FCCB investments. Premature redemption of FCCBs by way of buyback was permitted by RBI in December 2008, and recently, the RBI extended the window for buyback of FCCBs to March 31, 2012. Yet, only a few companies were able to capitalise on this opportunity due to the low liquidity in FCCBs. Buybacks are supported by the government, as they reduce potential forex outflow.

For example: <>Jubilant Life Sciences had raised more than USD $275 m by selling FCCBs overseas. The conversion price for bonds maturing on May 2010 was fixed at Rs 377.9, and for those maturing on May 2011 was fixed at Rs 588.9. However, the stock price tanked to 150. As a result, Jubilant repurchased FCCBs worth USD $48.3 m due in 2010 and 2011 for an aggregate cash amount of USD $40.55 m. In-fact it offered to buy back its entire outstanding FCCBs of about USD $248 m in the second tranche, but received poor response, and so could it purchased only USD $48.3 m. This was because the tender offer was much below the conversion price.

Repayment through existing cash, cash equivalents and operating cash flows: If bond issuers have sufficient cash and cash equivalents on their balance sheet, they can use this to repay the FCCB holders. This payment is done at full redemption value as opposed to Buybacks, which can be executed at a discounted rate and so the latter is more beneficial to bond issuers.

Refinancing of debt: The issuer takes new debt through banks. RBI has permitted issuers to avail of fresh ECB or FCCBs to finance the redemption of an existing FCCB under certain conditions. Availing of this alternative, will lead to higher interest rates and add to existing debt burden.

Issue of additional new equity to repay debt: The FCCB issuer can raise additional funds through dilution of equity to repay the incremental debt assumed to redeem the FCCB. This route might be a possibility for companies with high promoter holding, since the detrimental impact of dilution can be palatable. Though, in general, promoters are understandably reluctant to dilute their stake and that of other existing shareholders.

2012 India Inc.’s FCCBs - A Disaster in the making

Many of India Inc.’s FCCBs will mature in 2012. However, since stock prices have tanked and conversion of debt to equity cannot take place, companies are confronted with redemptions. This will negatively impact cash flow and increase their debt/equity ratios.

Overall, it is a great lesson for India Inc. to deal with the "black swan event" of stock prices falling much below FCCB conversion levels. By not thinking this scenario of market prices being lower than conversion prices, they did not anticipate the risk of non conversion of FCCBs.

Now, India Inc should accept the huge error they have made due to their blind spot, and be prepared for the worst case scenario before making any new investments.

For retail investors, before investing in a stock, it would be prudent for to look at the extent of debt companies are carrying, and the degree of exposure to FCCBs. Additional insights on how the company will cope with the pending crisis can be gleaned by studying how funds raised through FCCBs are being used. Companies that have used FCCB proceeds to fund inorganic growth or acquisitions at exuberant valuations could be in for a more than a spot of trouble. Acquisitions take a while to fructify, and in this environment of FCCBs being redeemed, these companies will experience a severe strain on their cash-flows and earnings.

Investors beware. We believe, "black swan or not", that there is an impending disaster for the companies in India Inc. that have FCCBs maturing in 2012, and that have high debt/equity ratios. And these companies are likely only now realizing the consequences of their actions.

By Equitymaster - A leading ‘independent’ research initiative focused on providing well-researched and unbiased opinions on BSE and NSE Stocks.

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