Prefer regular interest payments to future gains

August 5, 2012:

Suzlon Energy raised $300 million through zero coupon Foreign Currency Convertible Bonds (FCCBs) in May 2007, offering investors an option to convert these into shares at Rs 359 in 2012. This was a near 60 per cent premium to the stocks market price of Rs 226 then.

But post global financial crisis and stock market meltdown, in the FCCB issue made in April 2011, Suzlon set the conversion price at just Rs 54. The stock ruled at Rs 49. A steep come-down from the optimistic valuation of the pre-crisis years. These bonds also carried an interest of 5 per cent per annum.

Clearly, foreign investors now prefer regular interest on bonds, rather than the prospect of profits on conversion to shares a few years down the road.

Suzlon is not an isolated case. In March 2008, Tata Motors raised zero coupon yen-denominated FCCBs with a conversion price of Rs 1,001 exercisable in 2011. The stock ruled at Rs 623 then. An FCCB raised just 18 months later by the company saw the conversion price cut to Rs 624.

Indian companies have not sworn off FCCBs after the credit crisis, but lenders have certainly begun to insist on more conservative terms of conversion.

An analysis of FCCB issues shows that buyers of these bonds now insist on conversion prices that are closer to prevailing market prices, than before. More of these bonds also carry annual interest payments, compared to the practice of issuing zero coupon bonds earlier.

FCCB issues by Indian companies prior to 2008 assumed an average compounded annual return of 6.6 per cent between the time of the issue and the actual conversion into shares. The FCCBs after 2008 expect a stock price return of only 3 per cent. This can be attributed to the fact that pre-2008 investors were quite bullish about prospects for Indian companies and expected high earnings growth. This made them more comfortable about accepting high conversion prices, as they felt that they could still pocket a substantial gain on the stock. With most lenders expecting to exercise the conversion option, they didnt bother about coupon payments either.

Since 2001 there have been 291 deals in FCCB bonds by Indian companies. Total money raised was around $26.5 billion. FCCB issuances picked up from 2004 with deals worth around $2.2 billion that year. They peaked in 2007 with deals worth around $7.5 billion. In the current year, FCCB issues have raised $230 million through just two deals.

The practise of issuing zero coupon FCCBs with high conversion prices also arose from their tax advantage. While interest payments on bonds suffer a withholding tax, the gains from converting them into shares are subject only to long-term capital gains tax, which may be quite low in some jurisdictions.

FCCBs are convertible instruments. The bondholders have an option to convert each bond into shares at a fixed conversion price, before it comes up for repayment. Else, they can hold it to maturity to receive interest payments as well as the face value of bonds at the time of redemption.

(This article was published on August 5, 2012)