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The Upcoming FCCB Problem

There has been consternation about Foreign Currency Convertible Bonds, or FCCBs recently, and this is a more detailed post on them.

What are FCCBs

An FCCB is basically like this:

  • You give me dollars

  • I give you “bonds” that have a coupon interest rate, which I don’t pay you, it accumulates over the period.
  • At the end – or anywhere in between – you can convert some or all of your bonds, with accrued interest, into equity shares at a predefined “conversion” price.
  • If you don’t convert, I pay you bank the principal plus interest, in dollars.

Most offerings had conversion prices at a “premium” to the then market price, assuming, as investors do, that stocks only go up in the long term. Interest rates, or “coupons”, were at zero percent or extremely low figures of 1-2% . The typical term of an FCCB was five to seven years.

What’s the problem?

India went gung-ho on FCCBs in the 2004-07 timeframe, when stocks went nuts. This is now reaching redemption zone, and hurting.

More than 50,000 cr. worth FCCBs are nearing maturity soon, and of this the next two years will see between 35,000 and 40,000 cr. worth of bonds maturing. Conversion prices are far above current market prices, so the companies have to pay investors back.

What can companies do?

Their choices are:

  • Borrow in dollars, through more FCCBs, to pay back current investors: That will probably take a leap of faith because investors have been burnt badly. Conversion prices will be required to be much lower, meaning more dilution for existing shareholders. Coupon rates will also need to be higher – after all, if Italy is paying 7% for its bonds, you can’t expect an Indian midcap corporate to pay much lesser.
  • Change the conversion price of the bonds to near market prices. Considering that some issues have conversion prices 90% below conversion prices, a drop to market price will mean 10x the dilution of the share. Take Subex – it has to pay $131 million or convert at a price of 646 in one tranche and Rs. 80 in another; the stock price is at Rs. 34.45 today. (Additionally lowering conversion prices may need RBI approval, or breach FDI limits)
  • Repay through cash or selling assets. ET says some can – like JP Associates, FT, L&T or Moser Baer.
  • Raise cash through equity offers: Companies can use rights issues, an FPO or a private placement. Given the situation in the market, these options look bleak.
  • Default. This is the least preferred option but it’s what companies will have to do if they can’t do any of the above steps. Zenith Infotech defaulted recently. If a default occurs, the lenders will take the company to court, and most likely require it to be wound up and assets sold to recover their money. Importantly, this will hurt all other lenders – even domestic banks that have lent money – as such an action will prompt them to have to restructure or write-off their loans as well.

The problem is compounded by…

The Rupee Fall

When the FCCBs were taken, the rupee was at values of Rs. 40-44. Today, the rupee is at Rs. 52 to a dollar. That means to buy the same number of dollars and pay back, companies need to pay 20% more! This is apart from the coupon interest; and given that if they try to pay back the FCCBs, they will end up flooding the market with buy orders, the rupee will fall even more.

This rupee fall hurts “conversion” as well. Consider an FCCB issue with the dollar at 44, and a conversion price of Rs. 440. That means one share = $10 worth. Today, even if the stock stays at Rs. 440, it will be worth just $8.46 – a loss of 15%. To break even, the stock needs to be at least Rs. 520.

This hurts more when companies borrowed to deploy money in India – if they used the funds abroad, the return on those funds would also be in dollars so the impact is lesser.

What has happened?

Zenith Infotech defaulted on $33 million worth of FCCB repayments in October. But it sold a part of the company, Zenith RMM, to a fund called Summit Partners at an undisclosed amount, and the remaining shareholders have gone to court saying dudes, if you got that money, you gotta pay us. Summit has said they will share transaction details if they are kept out of reach of other bondholders.

Tata Steel offered to increase coupon rate from 1% to 4.5% if bondholders increased the tenure from 2012 to 2014, which it could do because of its size.

Wockhardt attempted a default, and after investors went to court, will pay back the 473 cr. it owes, over five tranches till Oct 2012. Interestingly, secured local lenders like SBI and ICICI have claimed a higher seniority on their loans compared to the unsecured FCCB holders, which means they want to get paid first. Let’s see how that develops.

Investors dump FCCBs, says Livemint:

Yields on the bonds of other top companies such as Financial Technologies (India) Ltd ($100 million, or Rs514 crore today) increased from 6.977% to 20.395% and Reliance Communications Ltd ($1 billion) from 6.629% to 28.993%.

The yield on 3i Infotech Ltd’s €30 million (Rs207 crore today) bonds increased from 24.52% to 41.15%, while that on another set of $100 million bonds rose from 18.117% to 24.45%. Hotel Leelaventure Ltd’s $100 million bonds saw yields increase from 10.519% to 18.393%.

Similarly, yield on Sterling Biotech Ltd’s $100 million bonds rose from 13.08% to 98.098%. Moser Baer India Ltd’s two set of bonds have seen yields rise from around 45-48% to 300-340% so far this year. The yield on JSW Steel Ltd’s $325 million bonds tripled from 3.15% to 10.664% in the last 11 months.

In Conclusion

It will be important to keep FCCB redemptions in mind as the months go by, and to track them. I’m building an excel sheet to see if prices move suddenly on the FCCB repayment due stocks, and will in general avoid going long on them unless they are actually able to pay their dues properly. But a lot of things will be impacted, as Rs. 50,000 cr. is not a small amount; the dollar-rupee rate, and thus the price at which we buy oil, and thus inflation.

If there are many defaults, the banking system might be hit as well. This is more of a “beware” post than an action post; more on individual companies and an FCCB List later.

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