The Murphy’s law of foreign currency convertible bonds
The complex nature of the product means that many things can go wrong
Foreign currency convertible bonds (FCCBs) are back in the headlines, and once again it’s for all the wrong reasons.
As the name suggests, FCCBs are bonds issued in a foreign currency that give investors the option of converting them into equity. The coupon rates on these bonds are often lower because they offer investors the chance of benefiting from an upside in the equity of a company. An investor who subscribes to these bonds accepts a lower coupon rate in return for the potential benefit that accrues at the time of conversion. A conversion price is fixed at the time of the agreement. When the bonds mature, if the shares are trading above that price, bondholders can convert their bonds into equity. Else, they settle for redemption of bonds.
The product, by its very nature, is a complex one and involves not just a judgment on the credit profile (and risk profile) of a company but also its growth prospects, which then determines how its share price will move. The complexity of the product has grown over the years and now some of these issues make conversion mandatory if the share price goes well above the conversion price.
The complex nature of the product means that many things can go wrong. And just like Murphy’s law, all that can go wrong, will go wrong.
Take the recent case of Castex Technologies Ltd. On Thursday, Castex informed the exchanges that it has allotted shares to bondholders following a mandatory conversion of bonds. The bonds were converted after shares went above a pre-fixed price (Rs.171.08 for one tranche of bonds, and Rs.153.36 for another). However, between the time the conversion was triggered and the shares were allotted, shares of Castex plunged to just Rs.40.35, which means the bondholders are sitting on huge losses.
The bondholders approached the Securities and Exchange Board of India (Sebi) to stop the conversion, alleging price manipulation. But as Mint reported on Thursday, the regulator will not intervene even though it is probing allegations of manipulation in the stock price. The regulator is fully justified in arguing that these bondholders are among the most sophisticated investors in the market, and that they should have been well aware of the risk associated with the product. Their credit analysis of the company should have also thrown up possible risks. It could justifiably be argued that the bondholders did not do adequate homework before investing.
Some in the market are arguing that Sebi should intervene to protect the integrity of the market. But the fact of the matter is that FCCBs are niche products which have had a troublesome past. This has restricted the use of the product over the past few years. Also, there is no systemic risk here.
According to data from Prime Database, the big period for FCCB issuances was between fiscal 2006 and fiscal 2008. In 2005-06, Rs.22,590 crore was raised through such bonds, which rose to Rs.25,433 crore in 2006-07. In 2007-08, Rs.24,243 crore was raised, after which issuances dwindled. This stock of FCCBs ran into trouble as share prices fell sharply after the financial crisis of 2008. This, in turn, meant that these bonds could not be converted into equity and Indian firms were left staring at huge redemptions. Because the redemptions were large and had the potential to a pose a systemic risk, regulators were forced to intervene.
In 2008, the Reserve Bank of India (RBI) allowed companies to buy back their FCCBs from the secondary markets at a discount on a case-by-case basis. Later, the RBI further liberalised the scheme and allowed such buybacks under the automatic route. The thinking was that the since the FCCB crisis was brought on by external factors (the global financial crisis), regulatory intervention was justified and needed.
Although FCCB issuances fell, instances of trouble caused by these instruments kept cropping up.
There have now been a number of cases where FCCB holders have dragged firms to court because of payment default. In some cases, winding-up petitions have been filed. In 2012, bondholders filed a winding-up petition against Zenith Infotech Ltd after the company failed to repay about Rs.450 crore. In the same year, bondholders dragged KSL and Industries Ltd, a company from the P.K. Tayal group, to court. The case was later withdrawn.
Larger firms like Suzlon Energy Ltd and Wockhardt Ltd have also been drawn into long battles with FCCB investors. Most recently, Jaiprakash Power Ventures Ltd had to reschedule payments on its FCCBs and extend the maturity date by a year since the stock price was below the conversion price and the group was finding it difficult to meet redemptions immediately.
Given this history, the controversy brewing around Castex Technologies should not come as a huge surprise. However, it should serve as a reminder that complex products come with complex risks.
There are now a number of fund-raising alternatives available to Indian companies, including the plain-vanilla foreign currency bond market which has become far more accepting of Indian credit. Overseas rupee bonds are also likely to become a reality soon once the regulator issues final guidelines. In addition, the domestic bond markets are also showing early signs of deepening.
Companies and investors would probably be best advised to stick to some of these less complex instruments.
Ira Dugal is assistant managing editor, Mint.
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