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.
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