Nov 23, 2010|
Basics of FCCBs
Investopedia defines a convertible bond as a bond that can be converted into the company's shares at a certain price on a certain date. The discretion of conversion usually lies with the bond holder. A Foreign Currency Convertible Bond (FCCB) is a special type of convertible bond which is issued in a currency different from the issuer's domestic currency.
As such a convertible bond is something that is a mix between a debt and an equity instrument. While it is a bond, it requires all the necessary features of a bond. There are regular interest payments to be made and at maturity the principal needs to be repaid as well. However, at maturity, or at a date before that, the bondholder can convert the bonds into equitable equity shares in the company. The price at which the bond will be converted into shares is decided beforehand. If the shares of the company never reach the predetermined price and the bond reaches its maturity, then the principal is repaid to the bondholder just like in the case of regular debt.
Why do companies issue FCCBs?
Companies issue FCCBs as the interest rate on them is much lower than that on a regular bond. The reason behind this is that the bondholder gets additional value in the form of the equity side of the bond. Therefore, from the company's perspective, it is easier to issue FCCBs as it reduces the interest burden for the company.
It also helps the company in raising money without diluting its value. Let us understand this with the help of an example. Suppose company A's shares are trading at Rs 100. It needs more capital and has the option to either issue fresh equity or to issue FCCBs. Suppose it decides to take the option of issuing fresh capital. It now needs to decide the pricing of the new shares. If it decides to price it higher than Rs 100, no one would subscribe to the issue as they can get the shares of the same company at a much lower price from the share markets. If it decides to price it at Rs 100 or below, then the investors would view this as the intrinsic value of the company as the management themselves have assigned this value to its own shares. The other option is to issue FCCBs. Suppose the company decides to issue FCCBs at a conversion price of Rs 200. This way the company gets the capital that it needs and there is no misinterpretation of the intrinsic value of the company. When the company's shares reach Rs 200, the bonds will be converted into equity shares of the company.
In recent times, FCCBs have proved to be an attractive source of raising capital for the companies. With rock bottom interest rates in the other countries, companies have raised huge amounts of FCCBs for funding their expansion programmes.
From an investors' perspective FCCBs have their own nuances. While it is a cheaper source of borrowing for the company; however, adverse movements in foreign exchange can impact the results of the company in a big way. Moreover, there would be an equity dilution when the bonds do get converted into equity shares.
The biggest problem with FCCBs occurs when the share prices of the companies start heading south. During market crashes and bear periods, the conversion price of the FCCBs becomes many times higher than the current share price. Under such circumstances, the issuing company has only two options. One is to pay the debt at maturity, which would need additional financing, which in turn is usually more expensive than the current debt. The second option is to revise the conversion price to a lower, more rational price. This again gives out a negative statement to the company's investors.
To conclude, while FCCBs are an attractive source of financing for a company, they have their own pros and cons. They do provide capital at relative lower interest burden. But they also make the company vulnerable to the fluctuations in the foreign exchange rates. FCCBs can turn out to be expensive when the prices of the shares are going down as they would need to be repaid through more expensive debt or through internal accruals. Finally FCCBs do lead to equity dilution at a later date. Therefore our advice to an investor would be to be careful if they see FCCBs taken by the company. It would be better to read the terms and accompanying notes carefully and analyzing them before investing in such a company.
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