Tamal Bandyopadhyay: Au revoir to the FCCB?

Global interest rates may be rising but the window of opportunity has not yet closed on FCCBs

Till about a year ago, FCCB was mostly an unfamiliar abbreviation in banking and financial circles. Today, just about everybody will tell you it stands for Foreign Currency Convertible Bonds.

Until recently, the FCCB was India Inc's latest craze. It is a foreign currency (usually dollar-) denominated bond that, in addition to offering a return or yield, also offers investors the option of converting their principal investment into equity at a pre-decided price. The price is decided when the instrument is issued.

Between July last year and now, 11 Indian companies have raised close to $1.5 billion worth of FCCBs. Another $1.5 billion or so was to have been raised over the next few months. The firming up of global interest rates and fall in equity prices in India markets may, however, prompt corporations to wait.

The window of opportunity appears to have shut "" at least temporarily. But how did the FCCB become the most favoured external commercial borrowing (ECB) technique in the first place? And has this market disappeared for good?

Let's examine the trend first. On April 19, Tata Motors launched a $400-million FCCB "" the largest international capital market offering made by an Indian company. The issue is also the first multi-tranche convertible offering by an Indian outfit, consisting of simultaneous issue of two different securities (called Tranche I and Tranche II).

Tranche I is designed to be almost like equity, whereas Tranche II is closer to straight debt. Tranche I ($100 million) is convertible at Rs 573.106 per share, representing a 17.5 per cent premium to the company's closing share price on the Bombay Stock Exchange on that day (Rs 487.75).

The second tranche ($300 million) is convertible at Rs 780.40 per share "" a 60 per cent premium to Tata Motors' closing share price on that day.

A day later, Zee Telefilms (ZTL) announced the listing of its $100 million FCCB on the Singapore Stock Exchange, including a $15 million greenshoe option (that is, the option to provide for over-subscription).

The bonds are convertible into newly-issued ordinary shares of Re 1 each of ZTL at a 35 per cent premium conversion price of Rs 197.24 per share.

Later that same week, India's second-largest truck maker, Ashok Leyland Ltd, announced an offering of $100 million worth of FCCBs to be traded on the London Stock Exchange, where the company's global depository shares (GDSs) are listed.

The bonds are convertible into either equity shares or GDSs, at the bond holders' option, at a conversion price of Rs 335 per share, a 21.6 per cent premium to the closing price of Rs 275.50 on the National Stock Exchange.

The bonds carry a coupon of 0.5 per cent a year and will be redeemable at par at the end of five years, if not converted into equity shares or GDSs during this period.

The April rally was kicked off by Sunil Mittal-promoted Bharti Group which raised a $115 million FCCB. The conversion price under the bond worked out to Rs 232, about a 40 per cent premium on that day's closing price.

The list does not end here (see table alongside). Mahindra & Mahindra ($100 million) and Tata Teleservices ($150 million) have since accessed the FCCB market and potentially a host of Indian companies are waiting to tap the market including Orchid Chemicals ($75 million), Sun Pharmaceuticals ($350 million) and Tata Power ($200 million).

Have these late-comers missed the boat? Well, one boat left on the first tide, for sure, but the ebb and flow of the capital markets will bring more opportunities.

The terms may not be so attractive the next time, given that dollar interest rates have been close to their historic lows and will not drop further. Indeed, the US Federal Reserve is hinting a rate hike and market swap rates have already risen in anticipation of this.

Says Pramit Jhaveri, managing director, head of India, Investment Banking in Citigroup Global Markets: "The FCCB window will not be continuously open, since interest rates are rising and the previous scarcity value of Indian paper is being filled by new supply. But the rewards will be there again for a select group of quality issuers who are prepared to seize the opportunity when it returns." Citigroup was book runner for six of the 11 FCCB issues that hit the market since July last year.

Certainly, Indian companies' eagerness to "dollarise" their balance sheets is understandable, given the low overseas interest rates and a relatively strong rupee against the greenback.

FCCB issuers also get to raise money cheaply. Consider this fact: IDBI raised money at 145 basis points over the London inter-bank offered rate (Libor), NTPC 205 basis points over the seven-year US Treasury rate and ICICI Bank at 106 basis points over Libor for straight debt issues.

This translates into a coupon of 4.75 per cent each in the case of ICICI and IDBI and 5.5 per cent for NTPC. In contrast, all recent FCCB issues of five-year maturity carried a coupon of a maximum of one per cent.

However, the real cost for the company is the yield to maturity (YTM) or the premium to be paid at redemption (that is, if the bonds are not converted into equity). The YTM of the FCCBs is between minus 100 basis points (Tata Motors) and 450 basis points (Tata Teleservices).

Yield to maturity is the compounded annual return whereas the coupon is the actual payment made to the investor on a yearly or semi-annual basis. Now, this return (the yield) can either be given to the investor over the period of the bond (in which case the coupon payment equals the yield and the bond is redeemed at par).

Or it can be back-ended (in which case the coupon is lower than the yield "" as has been the case with most Indian FCCB issues) and the additional return due to the investor is given in the form of a redemption premium.

If the coupon is lower than the yield, should the bond convert before redemption, the issuer will not have to pay the redemption premium. In that case, the cost of funds to the company would only be the coupon. However, it will be required to pay the YTM if the instrument remains on its books as debt.

If the FCCBs are converted into equity, corporations get a huge premium on the current market stock price (prices have fallen substantially since April when most of the FCCB deals were struck so the premium has shot up dramatically). The minium conversion premium is 19 per cent (for Indian Hotels) and the maximum is 60 per cent (for Tata Motors). Till April, most of these stocks had gained around over 200 per cent over the last one year. So, this premium would be achieved on top of a stock price that has already performed strongly.

This is no mean achievement considering that all vanilla equity issues have been priced at a discount to their market prices in recent times. Of course, conversion into equity is not certain and will depend on future share price performance. This is not the end of the list of advantages that corporations issuing FCCBs enjoy.

For instance, unlike debt, FCCB does not require any rating, nor any covenant like securities, cover and so on. It can be raised within a month while pure debt takes longer to raise.

Finally, because the coupon is low and usually payable at the time of redeeming the instrument, the cost of withholding tax is also lower for FCCBs compared with other ECB instruments. Withholding tax is payable at the rate of 25 per cent of the coupon. It is like TDS and is payable by the issuer on income remitted to a party overseas.

If the coupon is lower than the yield, as has been the case with most of the Indian issues, since a smaller amount is due to be paid every year in the form of coupon (and assuming conversion and not redemption takes place), the cost of withholding tax is lower.

There are, however, a few negative aspects of the instrument. For instance, since FCCB is treated as debt, it pushes up the corporation's debt equity ratio and dilutes earnings per share (EPS).

Why would an investor choose an FCCB? There are two reasons. First, this hybrid product offers many of the advantages of both equity and debt. It gives the investor much of the upside of investment in equity, and the debt element protects the downside.

Investors are chasing Indian paper because, over the last 18 months, 60 to 70 per cent of the FCCBs issued in Asia-Pacific have been from Taiwanese corporations. So investors want to bring down their exposure in one country by diversifying their portfolio. In this context, Indian papers come handy.

Three FCCBs issues in the past "" well before the recent rush "" were floated by IPCL, Gujarat Ambuja and Reliance Energy (formerly BSES). In all the cases, the instrument was backed by guarantees offered by banks to enhance the credit limit.

The IPCL paper was guaranteed by Citi and BankAm, Gujarat Ambuja by BankAm and Reliance Energy by Standard Chartered. However, none of the FCCBs floated now require bank guarantees. That shows Indian corporations' inherent strength in the overseas market.