THE STILL ATTRACTIVE FUND RAISING ALTERNATIVE –
GLOBAL CONVERTIBLE BOND MARKET

In the last twelve months most CFO- banker meetings have had one common point of discussion – Foreign Currency Convertible Bonds (FCCB). Given that over USD 6.4bn worth is due via FCCB redemption in 2012; the elevated interest in the asset class is not surprising.

What is fascinating; however, is the claim of companies that raised five year unsecured money without ongoing interest servicing requirements that this is expensive financing, notwithstanding that there has been no conversion into equity. Of similar nature are discussions on how the instrument should be non-dilutive or cause minimal dilution in case debt servicing is provided. These viewpoints highlight the lack of FCCB structure clarity. Sensational media attention and certain investor actions have led to maybe unnecessary negative perceptions. Stressful as they maybe, these are essential interactions so that after nine years and USD 24.4bn fund raise India can demystify FCCB.

Brief Overview of Global Convertible History

Convertible Bonds a.k.a CB (as FCCB are known typically) trace their origin back to 1880s, the era of American railroads. Getting debt for construction was expensive and there were few takers of uncovered equity risk. Financiers thus engineered an instrument which allowed companies to borrow cheaper money by permitting lenders to convert debt into equity and participate in the upside. In case the business and hence the equity did not perform, the debt was to be repaid at a fixed cost after a predefined tenor. It was a win-win situation. In Europe, the French, the master craftsmen of derivatives saw the agility of the asset class and had legal framework for CB issuance by 1950s. The global CB market saw a real flurry of activities starting in 1980s. Until 2008, United States and Japan were the two most important global CB markets while France and Germany ruled the roost in Europe. Most Asian issuance came from Korea and Taiwan. However, post Lehman, Japanese issuance dwindled while Asia-ex gained prominence.

Indian FCCB Market 2003 - 2011

India by then had tasted the varied flavours of the CB world. Until 2003 CB issuance from India was sporadic with only large firms tapping this market (e.g. Tata Steel, Mahindra & Mahindra, etc). In 2004 there were few Indian issues but by 2006 this product saw repeat issuers from India. 2007 could not contain the excitement of India Inc. Firms large and small, household names and little known firms all used the CB market to raise war chest funds, capex money or expansion financing.

However, as the economic crisis deepened and the decoupling theory lost ground, cracks appeared in the Indian CB world. Investors became credit sensitive and Indian issuers had to accept that India is a BBB- rated sovereign making majority Indian issuers high yield entities. Indian firms could no longer avail zero coupon benfits. At the same time the exuberance of Indian equity markets faded and Indian promoters could not convince investors that their stocks would return 70% plus in 3 – 5 years. Thus new issuance from India became sporadic.

What happened to outstanding FCCB was more interesting. In the days post September 15 2008, the cornerstone CB investors, the hedge funds, started facing redemptions and margin calls. They were selling any asset class that fetched them liquidity. With pressure not only on equity and debt markets but also fire sale of CB, the global CB index plummeted. Indian FCCB in their high yield stride took massive beatings. Bonds were trading anywhere from 10 cents to 50 cents to the dollar. While investors coped with the carnage, corporate India had respite in buying back paper they sold a couple of years ago at significant discounts.

So the question arises – if companies raised money that was not serviced either in dividend or coupon while they invested it in business to improve top lines and then earned profit by buying these securities back at bargain prices (Sine 2009, companies have bought back FCCBs worth USD 1.7bn – 19% of the issued amount); why is there an environment today that FCCB fund raise has wrecked havoc? The answer to this stressful question is perhaps simple – expectation mis-management.

CB STRUCTURE AND GLOBAL ISSUANCE PARAMETERS

The global CB market has a market capitalization of c.USD 500bn. Over 55% of issuers with outstanding paper are small and mid cap companies who raised growth financing via CB investors. Their issue parameters did not witness significant alternation post the economic slowdown. Average premiums remained around 25% and most issues carried upfront coupons of 3.5% - 5.0%.

It is in this respect that Indian issuance pre 2008 was different. Issuance from most Indian corporate irrespective of market capitalization carried premiums in the range of 30% - 40% (Average premium was 38.7%, 31.7% and 30.4% for 2005, 2006 and 2007 respectively) and there was no annual coupon. All interest was back-ended. In addition, while global companies restrict fund raising to an issue size to market cap ratio of typically below 30%, Indian issuers raised in excess of 30% of their market cap via FCCB.

Each one of the above mentioned considerations impacts the issuer’s financials and the investors’ return. The subsidized convertible debt for the issuer is because of the embedded equity option in the bond. The value of this option is determined inter alia by the conversion price (determined by the conversion premium), the time at which conversion may occur (American or European option) and the dividend paid on the stock. The lower the conversion price the higher the dilution (EPS and absolute) for the issuing entity, but the probability of conversion and possible return for the investor are also higher. Consequently a lower premium structure is more equity like with a larger debt subsidy. The more flexible the conversion right, higher are the chances that in case of a good share price run the debt will convert into equity before maturity; making the option more valuable for the investor and providing more equity like structure for the company. A low dividend also favours the probability of conversion and hence adds to the equity like nature of the instrument. Another important component of the issue is the size of the issue compared to the market cap and more importantly the free float of the company. If the number of shares that the bond converts into significantly increases the number of outstanding shares then there is a very likely negative share price pressure that can be caused at conversion. Thus this aspect needs to be monitored closely at the time of issuance.

The fixed interest rate determines the cash outflow required by the balance sheet in case of no conversion and the minimum return and a downside protection for the investor. Higher the interest rate, higher is the cash outflow for the company and minimum return for the investor. This makes the instrument more debt like. An annual coupon paid (part or whole of this interest cost) reduces the one time repayment burden on the balance sheet and also compensates the investor for the dividend loss reducing some of the debt like nature of the instrument.

Given these parameters, a balanced CB has a profile which offers the company some relief in interest rate and the investors a good possibility of participating in the upside of equity. This is the reason that the global CB universe has an average premium of ~25% and c. 90% of the issues pay annual interest rather than a zero coupon structure like Indian FCCBs.

THE STRUCUTRAL HICCUPS OF INDIAN FCCB AND THE UNNECESSARY SENSATIONALISATION

The problem with the structure of the Indian FCCB is that at the high conversion prices and low running coupons, the structure is more akin to debt than equity. Yet the instrument was sold as quasi-equity to issuers who did not provide for redemption dues and hoped for conversion.

 In addition, investors did not factor in the possibility that the market may fall and consequently the issue size to market cap ratio may become highly skewed against the issuers making it difficult for them to raise repayment funds.

The headline news attributed to FCCB redemptions, restructurings and rollovers is probably overplayed given that the money would anyway had to be returned to investors had it not converted. This is the implicit rule of the instrument. Annually multifold of this amount is part of bank rollover and restructurings. That does not attract as much attention as the money is understood to be repaid. A few investor actions (e.g. Wockhardt, Zenith Infotech) has made the market overlook the successful restructurings that investors participated in (e.g. Suzlon, Amtek)

All woes aside, the truth is that the CB investor base provided c.USD 25bn to India Inc, money which would not have come via the global equity or debt investors. In fact this is the most non discriminatory investor base which lent without rating or significant covenant requirements to companies across sectors and market capitalizations.

CASH RICH INVESTORS LOOKING AT INVESTMENT OPPORTUNITIES

Post Lehman the global convertible bond investor base has seen a shift towards the long only convertible bond investors. These investors raised new money in 2009 when the asset class was trading close to historical lows. However, since then the global CB issuance has reduced (given the economic slowdown) and most outstanding paper has matured. Thus the funds are today sitting on cash positions, looking for deployment opportunities. In fact it was these investors who anchored issues since 2009, including the Welspun issue which reopened the FCCB marketin September 2009. This stable investor base has ensured that in weak market sentiment there has been no fire sale of FCCB, leading to a better performance of FCCB vs. underlying equity.

Long only CB funds typically do not hedge equity or credit exposures and are in the investment for the long haul (3 – 5 years). However, in return for backing managements they like balanced structures which allow them a reasonable opportunity to participate in the upside. India Inc in this market of expensive domestic debt and challenging equity fund raise thus has a friendly investor base waiting to provide growth and incremental financing, albeit in a form such that neither the balance sheet nor the returns are unduly harmed.

Foreign Currency Convertible Bonds - Structural Variances and Conversion Decisions

The origin of convertible bonds can be traced back to the days of railroad development in the US. Since then the size of the convertible bond market in the US has grown making US the largest convertible bond market (both in terms of number of issues and investors) globally. As the market has grown (in and outside of the US) the convertible bond structure has also adopted several variations. Amongst the most straightforward variations is what is known as an FCCB in India, where the currency in which the debt is issued (a hard foreign currency e.g. USD) is different from the currency of the underlying shares (INR). Since the bond is issued in a foreign currency it is called a foreign currency convertible bond.

In its simplest form, a convertible bond (or an FCCB) can be issued as a fixed maturity debt issued at 100% of its face value, converting into the underlying shares at a fixed price (provided the shares trade above the conversion price), paying an annual cash coupon and if not converted then redeeming at a 100% of the face value at maturity. In this case, the issuer has a considerable cash outflow annually through the life of the bonds and the return for investors (assuming redemption) is the cash coupon on the bonds. This structure is most commonly known as par in-par out (or simply par-par) structure.

A slight variation to the above most straightforward structure is to defer a part of the annual interest payment to maturity. The investor receives part of the interest as an annual coupon while holding on to the bonds and the remaining interest is paid at maturity in addition to the face value. This implies that while the bonds are issued at a 100% of face value, at maturity they redeem at a premium to the issue price (the premium being equal to the deferred interest). Annually the bond accretes at a fixed rate such that at maturity the redemption amount is equal to the face value plus the deferred interest payment. The return for investors (once again assuming redemption) is the cash coupon and the premium redemption amount. The advantage for the issuer is that through the life of the bonds there is reduced cash outflow burden on the balance sheet. This structure is typically known as a premium redemption structure.

In both of the above cases if the bonds were to convert into the underlying shares, the return for investors would be greater. So let us focus on how investors take the decision to convert or not to convert. In order to understand the same let us take an example:

Illustrative Examples

Assumptions:

Issue Amount: USD 25m

Reference price (closing price of shares): USD 100
Denomination of bonds: USD 100,000

Premium: 25%
Years to Maturity: 5

Conversion Price: USD 125
Conversion Ratio: 800

1. Par – Par Structure

Annual Cash Coupon: 5.00%

Annual cash paid by the issuer: USD 1.25m
Total cash paid through 5 years: USD 6.25m

In this case there is no accretion of the bonds. The value of the bonds remains at the issue amount of USD 25m. The conversion decision thus rests on if the share price increases above USD 125 (the conversion price) to a level where converting the bonds would generate more income for the investor than holding on to the bonds and receiving coupon payments.

An example is below (to keep it simple, the example ignores PV calculations)

2. Premium Redemption Structure

Annual Cash Coupon: 2.00%
Rate of Accretion 4.95%

Annual cash paid by the issuer: USD 0.50m
Total cash paid through 5 years: USD 2.50m

In this case investors receive 2% cash coupon through the five years. To ensure that at maturity the bonds redeem at a value which compensates investors for the face value and the deferred interest, the bond accretes annually at 4.95%. The value of the bonds increases annually. The conversion decision thus rests on if the share price increases above USD 125 (the conversion price) to a level which generates more income than the annual coupon payments and the accreted value of the bond. Hence, the expected increase in the share price is more than that in case of a par-par structure.

An example is below (to keep it simple, the example ignores PV calculations)

The above examples highlight that a par-par structure while maximising the cash outflow also maximises the chances of conversion. Hence while issuing a FCCB; issuers should weigh the cash conservation attraction vs. the redemption risk very carefully.

An extreme case of premium redemption bonds is a zero-coupon FCCB where the entire interest obligation is deferred to maturity. This implies that the rate at which the bond needs to accrete is higher than that of a premium redemption bond further implying that the probability of conversion is lower than that of a premium redemption FCCB. The issuer in this case, however, conserves significant cash through the life of the bonds in order to invest in the business. With this idea, most Indian issuers have used the zero coupon structure while issuing FCCBs. Whether this has been the best decision in all cases is yet another discussion.

Foreign Currency Convertible Bonds - It is Equity upon Conversion

As discussed in the last piece, a convertible bond (CB) is debt at issuance and through its life, until converted into shares. Conversion into shares happens if the share price is above a certain share price (“conversion price”) either at maturity or through the life of the bonds. Typically on the day the convertible bond is priced, the volume weighted average price of the shares or the closing price of the shares is taken as a base price (“reference price”). Conversion price is then calculated as (reference price x (1 + conversion premium)), where the conversion premium is typically between 10% and 30%. The number of shares per bond is fixed by dividing the denomination of the bond with the conversion price. This defines the maximum number of new shares that can be issued at any time, limiting maximum dilution for existing shareholders.

In order to see how this works, let us take a simple example:

Assumptions
Issue Amount: USD 25m
Reference price (closing price of shares): USD 100
Denomination of bonds: USD 100,000
Premium: 25%

Outputs:
Conversion price: USD 100 x (1+0.25) = USD 125
Number of shares per bond: USD 100,000 / USD 125 = 800
Maximum number of new shares: (USD 25m / USD 100,000) x 800 = 200,000

Premium attained over the prevailing share price can be quite an attraction for issuers as it means using the same number of shares, a convertible bond can raise more money for an issuer compared to straight sale of the shares at the market price.

Illustration of maximizing funds raised via CB using the example above:

Sale of shares at market price raises: USD 100 x 200,000 = USD 20m
Extra funds raised via a CB: USD 25m – USD 20m = USD 5m

With CBs, issuers have the flexibility not to pay the dividends on the underlying shares (the shares into which the bonds convert) until conversion happens. This has an impact as dividend is paid from profits after tax while any coupon on the convertible debt gets a tax shield. For small and mid cap growth companies, prudently structured and priced convertible bonds can be quite an advantage. At early stages of growth it can be useful to raise cheaper debt (vis-à-vis conventional unsecured capital markets debt) and simultaneously defer any potential equity dilution (actual dilution occurs only upon conversion) that too at a premium to the current price.

One word of caution here pertains to the size of the CB relative to free float of a company and liquidity of its shares. Upon conversion, new shares of the company come into existence. This increases free float and affects liquidity. Some investors might want to sell the shares they receive upon conversion to realize gains. If the issue size is large relative to the free float and liquidity then sale of these shares is difficult. A downward impact on the share price can be a likely outcome if discounted selling begins. A sad truth is that some Indian corporates have raised money via FCCBs such that the issue size is over 50% of free float and represents over hundreds of days of trading volumes. Such high issue volumes also put an immense pressure on the balance sheet. As the share price underperforms, the issue size ratio to market cap only increases (issue size remains constant while market cap keeps reducing), implying a huge redemption obligation for the issuer. Going forward, in my humble opinion, Indian issuers must pay heed to the issue size and not get carried away.

While we discussed benefits of CBs for issuers, for investors, the option to participate in the upside of the company’s shares via a CB is also an appealing proposition. To begin with, in convertible bond participation, principal investment is protected unlike investment into equity capital of a company (in the worst case scenario shares under perform and bonds are redeemed for cash). If the shares perform well, beyond the premium level, investors can have 100% participation in the share price performance. For companies that have transparent and stable credit, this equity option is quite cheap (circa 5% - 15% of the total CB value) and hence can prove to be lucrative for the investor community.

Taking the same example as above, let us see how the share price at maturity impacts an investor’s decision to convert into the underlying shares or redeem the bonds for cash.

Share price at maturity: USD 120
Worth of the 800 shares per bond: USD 120 x 800 = USD 96,000
Value of each bond: USD 100,000

Hence the investor opts to redeem the bonds in cash as economically he is better of and gets his principal back (ignoring any interest for the time being). However, consider the following scenario:

Share price at maturity: USD 130
Worth of the 800 shares per bond: USD 130 x 800 = USD 104,000
Value of each bond: USD 100,000

In this case, the investor will want to convert into shares. If he sells the shares in the market then he gains USD 4,000 over the value of the bonds (ignoring any transaction costs and assuming share price remains constant). Thus we can see that as the share price increases, the incentive for investors to convert also increases.

Investors, whose mandates do not allow them to invest directly in equity, use convertible bonds as a proxy to get equity exposure. Equity investors like to invest in the riskier companies via convertible bonds to protect their principal. Fixed income investors look at convertibles as a yield advantage product while dedicated convertible bond investors use both the equity and debt characteristics of the product to make returns. Hence, convertible bonds are appealing to a wide ranging investor base.

Most Indian FCCBs have a high bond floor (please refer to the previous post for an explanation) and hence are more debt like. Thus, for India in particular, in the absence of sovereign international capital markets debt, FCCBs provide global investors an alternate means to get exposure to India credit.

There is large merit in the product, however, it needs to be structured and priced prudently. That will be highlighted in the next discussion piece.

Foreign Currency Convertible Bonds - It is Debt At Issuance

In the recent months there has been a lot of discussion in India around Foreign Currency Convertible Bonds (FCCBs) and how potential upcoming redemptions may “erode corporate profits”. While it is true that some of these bonds might not convert into underlying equity, it is an overstatement that ensuing redemptions will “erode” corporate profits.

At the time of issuance FCCB is debt. For an FCCB issuer, like any other credit obligation there is a cost of debt attached (ongoing fixed or variable cost), which the company has to pay either through the life of the instrument or at maturity. The capital repayment for an investor is through redemptions at maturity. The redemption can be in cash (akin to a bond) or in the form of shares. The instrument also allows an issuer to defer interest payments. In case of deferral of interest payments to maturity, redemption is done at a premium (premium equivalent to accrued interest) resulting in a balloon bullet repayment due at maturity. Thus for FCCB issuers who potentially have to redeem outstanding bonds at a premium in a couple of years, the redemption does not truly surmount to profit erosion as the debt would have been serviced in any eventuality. Instead of the issuer having to service the debt on an ongoing basis, it is now serviced as a lump sum at the end of the financing which can in many cases be a positive for the issuer from a time value standpoint.

As stated above, in case of FCCBs, investors have an option to get their money back in shares (of the issuing company). The number of shares per bond is fixed at issuance. As share price rallies, the value of shares per bond starts to increase. With a continuous increase in share price, there comes a point when it becomes more economical for investors to convert into shares (since the number of shares available per bond x share price is greater than initial amount invested in the bond, even with accrued interest) rather than redeem the bonds (which only generate a fixed return).

The above mentioned option to participate in the upside of the company’s equity has value for an investor. It has value for the issuer by subsidizing and granting flexibility to defer the interest payable on an FCCB in comparison with straight debt of the same entity. It will thus be fair to say that issuers who raised debt via FCCBs did so at lower rates vis-à-vis unsecured straight bond public placements in capital markets. These issuers had access to the much lower rates providing much needed free cashflows, particularly during their investment phase. Another benefit availed by these entities has been diversification of investor base away from the classic equity holders and banks, as is typical for most Indian corporates.

Given that FCCBs are hybrid instruments, accounting for FCCBs should reflect the debt and equity characteristics adequately. The net present value of the cash flows for the FCCBs gives the bond floor of the instrument. At issuance, the bond floor should be accounted for debt and only the difference between the FCCB amount and the bond floor should be booked as equity. Further, through the life of the instrument, the debt should accrete such that at maturity it is accounted for at par; fairly representing the liability. The rate of accretion should be taken as the effective interest rate (and not just the cash coupon). This interest rate should be charged to the P&L. Upon conversion the amortised debt is retired and replaced with corresponding equity. (as recommended in the exposure draft AS (30))

One concern with regards to FCCB issuance is that issuers have not accounted for the debt as described above. While the face value of the debt has been booked, the accretion has not been accounted for. At redemption when the premium is paid to the investor there will be an accounting mismatch causing a potential “loss” of value. However, the redemption in itself is not corrosive.

Bulk of FCCB issuance in India took place in 2006 and 2007. These instruments typically have a maturity of 5 years implying that most of the debt will be due for redemption / conversion in 2011 and 2012. With a recovery in the markets in the coming 3 – 4 years, it is quite probable that the share price of FCCB issuing companies will rally to levels such that investors will be better off converting into shares rather than asking for redemption. Thus it would not be prudent to make any judgement about value erosion at this point in time. However, it is advisable that companies with outstanding FCCBs follow the exposure draft on accounting standard AS (30) to avoid any surprises at redemption.