Understanding Foreign Currency Convertible Bonds

Introduction:

Foreign Currency Convertible Bonds (“FCCBs”) are a financial instrument used by companies to raise capital from international markets. Unlike standard bonds, which are issued in the domestic currency and carry fixed interest payments, FCCBs are denominated in a foreign currency. This feature allows companies to access foreign capital, often at more favourable interest rates than those available in their home country. Additionally, these bonds offer investors the option to convert their holdings into equity shares of the issuing company, blending debt and equity into a single financial product.

Key Feature:

FCCBs operate as hybrid instruments. On the one hand, they function like traditional bonds, providing periodic interest payments to investors and returning the principal amount upon maturity. On the other hand, they include an option for the bondholder to convert the bond into a specified number of equity shares at a predetermined conversion rate. This feature introduces an element of flexibility for both the issuer and the investor, as the bondholder can choose to maintain the bond as a fixed-income investment or convert it into equity, depending on market conditions and the performance of the issuing company.

Why FCCBs?

Companies are attracted to FCCBs for several reasons. One of the primary benefits is the lower cost of borrowing. Because the bondholder has the option to convert the bond into shares, the issuing company can offer a lower interest rate than it would for a traditional bond without a conversion feature. This reduction in interest payments decreases the overall cost of debt for the company. For companies with high growth potential, this is an attractive option, as it allows them to secure financing while preserving cash flow for operational needs.

Another advantage of issuing FCCBs is the access to foreign capital. Companies in emerging markets, such as India, often face limitations in raising funds domestically due to higher interest rates or restricted liquidity. By issuing bonds in foreign currencies, companies can tap into international markets where capital is more readily available and often cheaper. This access to global investors diversifies the company’s funding sources and can provide much-needed capital for expansion, research and development, or other strategic initiatives.

The option for bondholders to convert their FCCBs into equity shares also offers significant benefits to the issuing company. If bondholders choose to convert their bonds into shares, the company’s debt burden is reduced, as it no longer needs to repay the principal amount of the bond. Instead, the bondholders become shareholders, and the company gains additional equity capital. This equity infusion can strengthen the company’s balance sheet and improve its credit profile, making it easier to secure additional financing in the future.

For investors, FCCBs offer a unique combination of features that can be appealing in different market conditions. The bond’s interest payments provide a stable and predictable income stream, similar to traditional fixed-income investments

Risks and Drawbacks:

Despite their advantages, FCCBs carry certain risks that both issuers and investors must consider. One of the primary risks for issuers is currency risk. Since FCCBs are denominated in a foreign currency, issuers are exposed to fluctuations in exchange rates. If the local currency depreciates significantly against the foreign currency, the cost of repaying the bond can increase, potentially offsetting any savings from lower interest rates. For example, an Indian company issuing FCCBs in US dollars would need to pay more in rupees to service its debt if the rupee weakens against the dollar.

In addition to currency risk, issuers face the risk that investors may choose not to convert their bonds into equity. If the company’s stock price falls below the conversion price, bondholders are unlikely to convert their bonds, and the company will be required to repay the bond’s principal amount at maturity. This repayment can strain the company’s financial resources, particularly if it has not planned adequately for the eventual repayment.

For investors, the primary risk associated with FCCBs is also related to currency fluctuations. Since the bond’s principal and interest are payable in a foreign currency, the value of the investment can be affected by changes in exchange rates. A weakening of the foreign currency against the investor’s domestic currency can reduce the overall return on the investment. Additionally, investors face credit risk, as the repayment of the bond depends on the financial stability of the issuing company. If the company defaults or declares bankruptcy, investors may lose part or all of their investment.

Applicable laws:

Issue of Foreign Currency Convertible Bonds (FCCBs) and Ordinary Shares (Through Depository Receipt Mechanism) Scheme, 1993 introduced by the Indian government to facilitate Indian companies in raising capital through FCCBs and Global Deposit Receipts. FCCBs in India are also governed by guidelines set by the Reserve Bank of India (“RBI”) and the Ministry of Finance. Companies must comply with specific requirements regarding eligibility, investment limits, and pricing rules. For example, the conversion price of FCCBs must be determined based on an average of the company’s stock price over a specified period to ensure fair valuation.

Refinancing FCCBs is an option for companies facing challenges in repaying their bonds. Companies can issue new FCCBs or obtain external commercial borrowings (ECBs) to refinance existing bonds, provided they adhere to regulatory requirements. This process allows companies to manage their debt more effectively and avoid default. However, refinancing may require approval from the RBI, especially for larger amounts, and companies must ensure that the terms of the new bonds comply with existing regulations.

Tax Implications:

If the company pays interest to the bondholder, it will deduct 10% as Tax Deducted at Source (TDS) before paying the interest amount to the bondholder. Converting FCCBs to shares does not generate capital gains because the transaction is not considered a “sale” under Indian tax laws. Instead, it’s an exchange, and no profit or loss is realized at that point. After the FCCBs are converted into shares, any dividend paid on those shares will be subject to a 10% TDS. This is a standard rule for dividends paid to investors. This can be summarised as:

Conclusion:

In conclusion, Foreign Currency Convertible Bonds offer a flexible and cost-effective financing option for companies seeking to raise capital in international markets. Their hybrid nature, combining debt and equity features, provides benefits for both issuers and investors. Companies can access foreign capital at lower costs, while investors can enjoy the security of fixed interest payments with the potential for equity gains. However, the success of FCCBs depends on careful management of currency risks, market conditions, and regulatory compliance. Both issuers and investors must carefully evaluate these factors to maximize the benefits and minimize the risks associated with FCCBs.