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
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
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)
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.
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.
1 comment:
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