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.