Foreign currency convertible bonds (FCCBs) are proving to be a double-edged sword with large premiums simply vanishing on account of bear markets and the ghost of redemption at yield-to-maturity (YTM) hanging on. The pressure on issuers was also reflected in the performance of 185 private sector companies that issued FCCBs worth $20 billion in the last five years and many of whom could not convert those bonds into equity due to the end of the bull-run.
The 185 companies have fared badly with a 63.80 per cent decline in net profit in the third quarter compared to a decline of 17.5 per cent in the second and 3.3 per cent in the first quarter. The remaining 2,268 private sector companies that did not borrow through FCCBs fared well in relative terms. These companies reported a 47.6 per cent decline in net profit in the quarter under review.
Currently, most companies do not charge the redemption premium to the profit and loss (P&L) account on the assumption that bonds will finally be converted into equity shares. In the third quarter, only 69 companies made provisions of Rs 3,680 crore for currency fluctuations and reported a 65 per cent decline in net profit. Had all the FCCB issuers made provisions for MTM losses instead of overstating profits, the corporate results would have been even worse.
Over the past few years, Indian corporate houses have aggressively used FCCBs to raise cheap funds to finance their growth plans. FCCBs, with their low coupon rates and high conversion prices in relation to prevailing stock prices, were then an extremely attractive proposition. Indian companies have borrowed almost Rs 100,000 crore from overseas investors through the FCCB route. However, steep corrections in stock prices in calendar 2008 have unraveled the dark side of FCCBs.
The 185 companies studied here have a total debt of Rs 213,277 crore in their account book for 2007-08 compared to Rs 100,102 crore in 2005-06. Of the total debt, unsecured loans accounted for Rs 116,607 crore, up from Rs 38,762 crore in 2005-06, indicating heavy borrowing through FCCBs.
These companies spent Rs 150,000 crore on purchases of fixed assets in the last three years but accrued benefit on these investments is yet to come. Though the net cash flow of the 185 companies from operating activities increased sharply by 162 per cent in 2006-07, it rose at a slower pace of 6.8 per cent in 2007-08. During the first nine months of the current financial year, these companies reported a 4.2 per cent decline in operating profit, indicating further slowdown in economic activities.
| CHEAP MONEY BLUES | ||||||
| Company name | Interest | Net profit | Unsecured loans | |||
| Apr-Dec 08 | % chg | Apr-Dec 08 | % chg | 2007-08 | % chg* | |
| Reliance Comm | 937.9 | 700.7 | 1213.2 | -41.5 | 19336.4 | 104.5 |
| Suzlon Energy | 224.3 | 141.6 | -285.9 | ** | 2412.5 | 561.2 |
| JSW Steel | 582.4 | 90.5 | 409.3 | -69.9 | 2049.5 | 279.2 |
| Tata Motors | 581.3 | 75.6 | 409.8 | -72.5 | 3818.5 | 92.2 |
| Tata Steel | 844.8 | 47.3 | 3742.5 | 7.5 | 14501.1 | 146.3 |
| * = Percentage change over 2006-07 ** = Net profit of Rs 783.2 crore in April-December 2007 | ||||||
According to a research analyst at Edelweiss Research, for companies where FCCBs are likely to be redeemed, profits are overstated to the extent of the true cost of the 'debt' or YTM is not reflected in the P&L account. The YTM, or effective interest cost, is lower than that for the comparable debt due to the embedded call option. These companies will face refinancing risk, which is significant in the prevailing tight credit environment.
The redemption call on FCCBs will be required to be financed by a mix of surplus cash, internal accruals and fresh debts. Refinancing FCCBs with fresh borrowings will significantly increase leveraged position of these companies and their interest expenses, adversely impacting profitability. In the event of non-conversion of FCCBs, there is a repayment premium that will hit profits.