Foreign Currency Convertible Bond 100 marks project

Foreign Currency Convertible Bonds

INTRODUCTION

Foreign Currency Convertible Bonds are attractive to both investors and issuers.

The investors receive the safety of guaranteed payments on the bond (if interest

payment is involved) and are also able to take advantage of any price appreciation

in the company’s stock. Bondholders take advantage of this appreciation by means

of warrants attached to the bonds, which are activated when there is substantial

price appreciation of the stock. Due to the equity side of the bond, the coupon

payments on the bond are lower, thereby reducing its debt - financing costs for the

issuer.

FCCB are also referred as FCCN (Foreign Currency Convertible Notes) by some

issuers. Bonds of foreign countries are called by various names in International

markets. For example in US, overseas bond listed with SEC are called Yankee

Bonds, while they are referred to as Bulldog Bonds (in U.K.) and Samurai Bonds

(in Japan).


Salient Features

FCCB is a quasi-debt instrument, which can be converted into a company’s

equity shares if the investor chooses to do so, at a pre-determined strike rate.

FCCB issues have a ‘Call’ and ‘Put’ option to suit the structure of the Bond.

A call option entitles the issuer to “Call” the loan and make an early

redemption. On the other hand, a put option entitles the lender to exercise

the option to convert the FCCB into equity, both the options are subject to

RBI guidelines.

The interest component or coupon on FCCBs is generally 30 per cent -40

per cent less than on normal debt paper or foreign currency loans or ECBs.

This translates to cost saving of approx 2-3 percent p.a.

The coupon on bonds can also be zero as in case of zero coupon Bonds

(ZCB) in view of attractiveness of options attache to them. In case of ZCB,

the holder is basically interested in either conversion of the bondin equity or

capital appreciation.

The redemption of FCCB can be made at a premium or at par or even at a

discount depending upon the coupon offered. The Present value of overall

remaining cash flow determines the valuation of Bonds e.g. out of 3 series of


FCCN issued by Tata Motors Limited, 1 per cent FCCN of 2003 are

redeemable on July 31 2008 at 116.824 per cent of Principal, whereas Zero

Coupon FCCN of 2004 will be due for redemption at 95.111 per cent of

principal.

The Yield to Maturity (YTMs) in case of FCCBs normally ranges from 2 per

cent to 7 per cent.

FCCB are generally issued by Corporate, which have high promoter

shareholding and hence do not perceive any risk of losing management

control even after exercise of conversion option.

The pricing of the FCCB options is generally between 30 per cent – 70 per

cent premium over the Current Market Price giving sufficient cushion to the

issuer. The FCCB opts to convert the FCCB, in case the market price

exceeds the option price or if there is an intent to make strategic investment

by the lender irrespective of the stock price in market.

In many cases, the FCCB issuer as well looks forward to exercise of option

by lender, so that there is no fund outflow on redemption. Instead the issuers

reserves are inflated by receipt of premium. If however, the FCCB holders

do not opt for conversion, the Issuer has either to reissue the bonds to same

holder or scout for a new lender. This also gives an opportunity for debt

restructuring.


The foreign holder of FCCB can trade the FCCB in part or in full. That is to

say, the holder can sell the debt part while holding the Option; or vice versa.

For example, if the holder is a mutual fund, interested only in equity, it may

retain the conversion option and sell the Bond, with a call option to, say, a

bank who does not want to take equity risk. The Bank thus buys debt portion

of the FCCB and draws a fixed income till the bond is called up. The seller

still retains the benefit of equity and can call up when stock price is

substantially less than the conversion price - without sacrificing the

liquidity.

The issuance of FCCB like any incremental borrowing invariably requires

the approval of existing consortium of lenders.

FCCB can be secured as well as unsecured. Most of the FCCB issued by

Indian Companies are generally unsecured.

FCCB can be subordinate to existing debts or they can be unsubordinated on

case to case basis depending upon the structure of the deal, its timing and the

present gearing.

FCCB can be converted into Indian Shares or American Depository Shares

(ADS). The allottee is free to dispose of the shares so received upon

conversion any time after allotment, if there is no lock in clause.

FCCB issue expenses as well as premium on redemption of FCCB are

generally charged to Securities Premium Account.


While a credit rating or Bonds is not mandatory, since Bonds are mostly

issued by top corporate having excellent track record, rating definitely helps

to price the Coupons competitively.

The issuing company need to hedge its forex exposure arising out of FCCB,

till the time of redemption or conversion.

The right to convert the FCCB into equity can arise any time, starting

immediately after allotment and can vest for 2-3 years.

FCCB carries fewer covenants as compared to a syndicated loan or a

debenture, hence these are more and more convenient to raise funds.

FCCB are generally listed to improve liquidity, generally Indian issuer have

listed at Singapore Stock Exchange and in many cases also on Luxembourg

Stock Exchange.


Eligibility For Issuing FCCB

The FCCBs to be issued will have to conform to the FD policy (including

sect oral cap and Sectors where FDI is permissible)

An issuing company is required to obtain prior permission of Department of

Economic Affairs, Ministry of Finance, Government of India.

An Unlisted Company issuing FCCB is required to be simultaneously listed

in the Indian Stock Exchange(s).

An issuing Company must have a consistent track record of good

performance (financial or otherwise) for a minimum period of three years.

Statutory Guidelines RBI regulations:

FCCB have been extremely popular with Indian Corporate for raising Foreign

Funds at competitive rates. FCCB are treated as Foreign Direct Investment (FDI)

by Government of India. The Government has also liberalized FCCB guidelines

from time to time to give impetus to infrastructure development and expansion

plan of Corporate India.

The latest comprehensive guidelines on FCCB are contained in external

commercial borrowings (ECBs) guidelines issued by RBI on 1st August, 2005 vide

circular no 5 A.P. (DIR Series). The circular is fully applicable for FCCB issuance

as well.


The key highlights of RBI guidelines are as follows:

ECB/FCCB can be raised under Automatic route (for specified Industries

only on meeting specified conditions) or on RBI approval. RBI has set up an

empowered committee to consider requests for approval.

The automatic route is available to real sector i.e. Industrial sector, specially

infrastructure sector-in India, while all other sectors have to take RBI

approval.

The eligible borrowers under the approval route include Financial

Institutions dealing exclusively with infrastructure or export finance such as

IDFC, IL&FS, Power Finance Corporation, Power Trading Corporation,

IRCON and EXIM Bank are considered on a case by case basis. The list also

includes Banks and financial institutions which had participated in the textile

or steel sector restructuring package as approved by the Government are also

permitted to the extent of their investment in the package and assessment by

RBI based on prudential norms. Any ECB availed for this purpose so far are

deducted from their entitlement.

RBI has recently issued a circular no A.P.(DIR Series) No. 15 dated 4th

November, 2005 , whereby Special purpose vehicles (SPV) or any other

entity notified by RBI set up to finance infrastructure companies or project

will also be treated as Financial Institutions for the purpose of consideration

of their application under approval route.


The guidelines as stated hereunder are generally same for approval as well

as automatic route except as stated.

Minimum Average Maturity of FCCB shall be 3 years for borrowing up to

US$ 20 million and 5 years in case it exceeds US$ 20 Million.

The maximum amount of ECB to be raised in a financial year can be US$

500 Million. However, there is no limit on numbers of FCCB to be issued or

the size/value of each instrument.

ECB/FCCB up to US$ 20 Million can have call/put option, provided the

minimum average maturity period of 3 years is complied with.

The maximum all in all cost to be incurred on ECB/FCCB cannot exceed

following limits:

1. Average Maturity period of 3-5 years-200 bps over 6 month LIBOR.

2. Average Maturity exceeding 5 years-350 bps for over 5 years LIBOR.

There are strict guidelines for monitoring of end use of ECB proceeds. RBI

stipulates that ECB proceeds can be used for

(a) Investment purposes like Import of Capital goods, New projects,

modernization/expansion programmers in Industrial and infrastructure sector.

(b) Overseas direct investment in JV or wholly owned subsidiaries

abroad.

(c) Acquisition of shares in divestment process etc.


RBI Guidelines specifically prohibit use of ECB proceeds for on lending,

investment in capital market, Company takeover etc. RBI Guidelines also

specifically prohibit use of ECB proceeds for Real estate Sector, however

this can be used for development of integrated townships as defined by

Government.

No Guarantee, Letter of Comfort, letter of Undertaking can be issued by

Banks, FIs or NBFC relating to FCCB. Recent RBI circular dated 5th

November, 2005 permits banks to issue guarantees, standby letters of credit,

letters of undertaking or letters of comfort in respect of ECB by textile

companies for modernization or expansion of their textile units under

approval Route subject to prudential norms. This is likely to facilitate

capacity expansion and technological up gradation in the Indian textile

industry after the phasing out of Multi-Fiber Agreement.

The issue of security is left at the discretion of Issuer Company, subject to

other extant guidelines. In case any charge is required to be created on

immoveable properties or on any financial securities in favors of lender, then

such charge can be created as per provisions of FEMA.

One of the major changes introduced by RBI is checking the credentials of

lender by seeking certificate of due diligence issued by their Overseas

Banker. In case of Individual lender, the Bankers verification is required. If

“Know your Customer Guidelines” are not implemented in the country of

residence of Lender, then such lenders cannot finance under FCCB.


Prepayment of FCCB is permitted up to US$ 200 Million subject to

compliance of minimum average maturity period. For higher prepayment

amount, RBI approval is needed.

RBI guidelines provide that funds received through FCCB should be parked

abroad till the actual requirement arises in India. This has been necessitated

due to bloating forex reserve of India, which has led to huge depreciation of

rupee vies a vies US$. RBI has also clarified that the parked funds can be

invested in short term liquid assets so that they can be easily liquidated when

the funds are needed in India. The permitted mode of investment are

(a) Deposits or Certificate of Deposits etc offered by Banks of approved

rating

(b) Deposits with overseas branch of Indian AD.

(c) Treasury bills and other monetary instruments of one year.

FCCB Issuers are required to submit Form 83, in duplicate, certified by the

Company Secretary (CS) or Chartered Accountant (CA) to the designated

AD. One copy is to be forwarded by the designated AD to the Director,

Balance of Payments Statistics Division, Department of Statistical Analysis

and Computer Services (DESACS), Reserve Bank of India, Bandra-Kurla

Complex, Mumbai – 400051 for allotment of loan registration number and

the amount can be drawn only after obtaining the loan registration number

from DESACS, RBI.

The borrower has to be file ECB – 2 return on monthly basis with RBI

within 7 days of end of month.


Major Changes in August 05 guidelines of RBI

RBI has introduced major structural changes in its

ECB policy to promote the growth of infrastructure sector as well the Housing

Finance Companies. The guidelines also seek to curb money laundering.

Non-banking financial companies (NBFCs) have been permitted to raise

ECB/FCCB with minimum average maturity of 5 years from multilateral

financial institutions, reputable regional financial institutions, official export

credit agencies and international banks to finance import of infrastructure

equipment for leasing to infrastructure projects under Approval Route;

Housing finance companies have been permitted to raise Foreign Currency

Convertible Bonds (FCCB) by satisfying the following minimum criteria: (I)

the minimum net worth during the previous three years should not be less

than Rs. 500 cores,

(ii) a listing on the BSE or NSE,

(iii) minimum size of FCCB is $100m

(iv) the applicant should submit the purpose/ plan of utilization of funds.

The only two HFCs which fulfill the criteria are HDFC and LIC Housing

Finance. HDFC has been looking to raise around $500m through an FCCB

issue. According to bankers, the new norms will deter smaller companies

from tapping this route;


This move is likely to benefit the country’s biggest mortgage lender HDFC

provided they have a minimum net worth of Rs. 500 crores;

The limit for prepayment of ECB without prior approval of RBI has been

increased to USD 200 million (as against the existing limit up to USD 100

million) subject to compliance of applicable minimum average maturity

period for the loan;

Currently, domestic rupee denominated structured obligations are permitted

by the Government of India to be credit enhanced by international banks/

international financial institutions/joint venture partners. Such applications

would henceforth be considered by the Reserve Bank under the approval

Route;

RBI has mandated that overseas organizations planning to extend ECBs

would have to furnish a certificate of due diligence from a bank abroad,

which in turn is subject to host-country regulation and adheres to Financial

Action Task Force (FATF) guidelines. It has been widely perceived that

promoters, having siphoned out money in the past through irregular forex

transactions, are bringing back the money through the ECB route.


Guidelines of Finance Ministry

The finance ministry recently issued amendment to the ‘Issue of

FCCBs and Ordinary Share (through Depository Receipt Mechanism) Scheme

1993’ to align it with SEBI’s guidelines on domestic capital issues. The

Government has barred tainted

companies to subscribe GDR and FCCB of Indian companies

The salient features of amendment are as follows:

For listed companies:

(a)Eligibility of issuer:

An Indian Company, which is not eligible to raise funds from the Indian

Capital market including a company which has been restrained from

accessing the securities market by the SEBI will not be eligible to issue

FCCBs and ordinary shares through GDRs;

(b) Eligibility of subscriber:

Erstwhile Overseas Corporate Bodies (OCBs) who are not eligible to invest in

India through the portfolio route and entities prohibited to buy, sell or deal in

securities by SEBI will not be eligible to subscribe to FCCBs and ordinary shares

through GDRs;


(c) Pricing:

The pricing of GDR and FCCB issues should be made at a price not

less than the higher of the following two averages:

(I) The average of the weekly high and low of the closing prices

of the related shares quoted on the stock exchange during the six months preceding

the relevant date;

(ii) The average of the weekly high and low of the closing prices of the related

shares quoted on a stock exchange during the two weeks preceding

the relevant date.

The “relevant date” means the date thirty days prior to the date on which the

meeting of the general body of shareholders is held, in terms of section 81 (IA) of

the Companies Act, 1956, to consider the proposed issue.

(d) Voting rights:

The voting rights shall be as per the provisions of the Companies Act, 1956 and in

a manner in which restrictions on voting rights imposed on Global Depositary

Receipt issues shall be consistent with the Company Law provisions. RBI

regulations regarding voting rights in the case of banking companies will continue

to be applicable to all shareholders exercising voting rights.


For unlisted companies:

Unlisted companies, which have not yet accessed the GDR / FCCB route for

raising capital in the international market would require prior or simultaneous

listing in the domestic market, while seeking to issue FCCB and ordinary shares

under the scheme. It is also clarified that Unlisted companies, which have already

issued GDRs/FCCBs in the international market, would now require to list in the

domestic market on making profit, beginning financial year 2005-06 or within

three years of such issue of Global Depositary Receipts / Foreign Currency

Convertible Bonds, whichever is earlier.

Pitfalls:

According to RBI, since companies can prepay their FCCB loans, overseas

investors could exit as soon as there is a downturn in economy and the interest

rates in overseas economy increase, even though the maturity period is for 5 years.

This could also lead to a spurt in the quantity of short-term debt in the country.

Moreover, while the current RBI Policy seeks to liberalize the fund raising

avenues, the excessive forex reserve in Indian economy is having a negative effect

on the earnings of IT and export companies.


Taxation on Foreign Currency Convertible Bonds

The pronouncements on tax treatment of Interest and dividend

payments on FCCB are contained in section 115 AC of the Income Tax Act, 1961

and summarized as under:

(1) Interest payments on the bonds, until the conversion option is exercised, are

subject to deduction of withholding Tax (TDS) @ 10 per cent.

(2) Tax on dividend on the converted portion of the bond are subject to deduction

of tax at source at the rate of 10 per cent.

(3) Conversion of FCCB into shares shall not give rise to any capital gains liable to

Income- tax in India.

(4) Transfers of FCCB made outside India by a nonresident investor to another

non-resident investor shall not give rise to any capital gains liable to tax in India. It

shall however be subject to capital Gain taxation rules of the country of residence.

The foreign resident is not required to file any return before the Indian Tax

Authorities, if its Indian taxable income contains only income from other sources.


FCCB Market & analysis of FCCB issued

The FCCB market is basically a limited market consisting

of FII, Banks, Mutual Funds and HNIs. As per a Study conducted by India Brand

Equity Foundation, India Inc emerged as the biggest issuer of foreign currency

convertible bonds (FCCBs) in the Asia-Pacific region in 2005. Total FCCBs issued

from India were to the tune of $1.4 ban, accounting for 32.7 per cent share, while

Taiwanese companies ranked second and raised $1bn. Further, out of about 30

FCCB issues in the Asia Pacific region, 15 were from India and 6 from Taiwan.

Indian companies that raised FCCBs from the marketing the year 2005 included

Tata Chemicals, Jaiprakash Associates, Glen mark, Tata Power, Bharat Forge,

Armtek Auto and Ballarpur Industries.

Corporate that hit the market in the first half of last year included Reliance Energy,

Indian Hotels, Bhatia Tele, and Ashok Leyland. The FCCB issuance of following

companies were studied and analyzed to gain an understanding of FCCB pricing,

its structuring and other related matters:

Tata Motors Limited

Tata Motors Limited has raised over US$ 400 Million through issue of FCCN

aggregating to Rs. 2215.56 Crores at issue. The first issue of FCCN was made in

2003 at a coupon of 1 per cent. The Note holders have an option to convert the

same into Ordinary shares or ADS at an initial conversion price of Rs. 250.745 at a

fixed exchange rate conversion. Company has raised US$60mn unsubordinated

unsecured Foreign Currency Convertible Bonds (FCCBs) due in 2010 to raise

funds for meeting capital expenditure and overseas investment and to prepay

existing foreign currency debt. The bonds will be convertible into Eurobond


Parma’s ordinary shares. The five-year zero-coupon 708 The Chartered

Accountant November 2005 bonds have a yield-to-maturity of 6.95 per cent per

annum and the convertible price has been set at Rs. 522 or 43 per cent to the

weighted average price of the company’s ordinary shares on the National Stock

Exchange of India Ltd. (NSE). The bonds will be issued at par and redeemed at

139.954 per cent of par on maturity. The issuer has the right to redeem all

outstanding bonds at their accreted principal amount on or after February 2008 if

the parity of the bonds (in US Dollar terms) trades for a specified period of time at

130 per cent or more of the accreted principal amount.

Tata Power Company:

Tata Power Company issued a $ 200 million foreign currency convertible bond

(FCCB) in Feb. 2005. The company had earlier launched a $200 million, 5-year

FCCB issue carrying a 1 per cent coupon, convertible at a 50 per cent premium

over the closing share price on February 8, 2005 and bearing a yield to maturity

(YTM) of 3.88 per cent compounded semi-annually. These bonds are listed on the

Singapore Stock Exchange.

Tata Teleservices:

Tata Teleservices successfully completed an issue of FCCB aggregating to US $

125 million in June 2004. The FCCBs are convertible into fully paid-up equity

shares of the company at the option of the FCCB holders at a conversion price of

Rs.24.96 per share. Up to March 31, 2005 FCCBs of US $ 46.96 million have been

converted.


Reliance Energy Limited:

Reliance Energy Limited has issued two series of FCCB till date, first being US$

120 Million, 0.5 per cent FCCB due on 25th Sep. 2007 and other US$ 178 Million,

ZCB due on 29th March, 2009. While the former FCCB (listed on Luxembourg

Stock Exchange) has an option to convert into GDR anytime after 25th Dec 2002

represented by Equity shares at Rs. 245 at fixed exchange price of 1 US$ = Rs.

48.35. The latter ZCB (Listed on Singapore Stock Exchange) are convertible into

Equity shares or GDR represented by Equity shares at a predetermined price of Rs.

1006.92 at a predetermined exchange rate of 1 US$ = Rs. 45.24.

Eurobond Parma:

Eurobond Parma Ltd. (APL) has raised US$60 man unsubordinated unsecured

FCCBs due in 2010 to raise funds for meeting capital expenditure and overseas

investment and to prepay existing foreign currency debt. The bonds will be

convertible into Eurobond Parma’s ordinary shares. The 5 year zero-coupon bonds

have a yield-to maturity of 6.95 per cent per annum and the convertible price has

been set at Rs 522 or 43 per cent to the weighted average price of the company’s

ordinary shares on the National Stock Exchange of India Ltd. (NSE). The bonds

will be issued at par and redeemed at 139.954 per cent of par on maturity. APL has

the right to redeem all outstanding bonds at their accreted principal amount on or

after February 2008 if the parity of the bonds (in US Dollar terms) trades for a

specified period of time at 130 per cent or more of the accreted principal amount.

The Bonds are listed on the Stock Exchange of Singapore.


Indian Hotel Limited:

Indian Hotel Limited Issued FCCB which reduced its cost of borrowings from 6.9

per cent to 3.6 per cent. Similarly, conversion of FCCB and repayment of loans

reduced its interest burden from by 36.5 per cent YOY from Rs. 91 man in Q1

FY05 to Rs. 58 mn in Q1 FY06.

United Phosphorous Limited:

United Phosphorus Limited made an issue of FCCBs aggregating to US $ 75

million, on 6th October, 2004. FCCBs aggregating to US $52.20 million have been

converted into equity shares as on 31.3.2 resulting in increase in the paid up capital

of the Company.

Jubilant Organosys Limited:

Jubilant Organosys Limited a composite pharmaceuticals industry player, has

announced its FCCB Scheme recently. The Company will issue FCCB for US$ 75

million (approximately Rs. 3.25 billion) unsecured having Zero coupon for 5 year

tenor with an upsizing option of US$ 25 million (approximately Rs. 1.08 billion).

The FCCB has a 50 per cent conversion premium at Rs.1365.32 per share. The

FCCB will be listed on the Singapore Stock Exchange. The FCCBs will be

convertible into Rupee stock listed on National Stock Exchange (NSE) and

Bombay Stock Exchange (BSE) or GDSs listed on Luxemburg Stock Exchange at

the option of the holder.


QUESTIONARIE

How does FCCB benefit a company?

Some companies, banks, governments, and other sovereign entities may decide to

issue bonds in foreign currencies because:

• It may appear to be more stable and predictable than their domestic currency.

• Gives issuers the ability to access investment capital available in foreign markets

• Companies can use the process to break into foreign markets.

• The bond acts like both a debt and equity instrument. Like bonds it makes regular

coupon and principal payments, but these bonds also give the bondholder the

option to convert the bond into stock.

• It is a low cost debt as the interest rates given to FCC Bonds are normally 30-50

percent lower than the market rate because of its equity component.

• Conversion of bonds into stocks takes place at a premium price to market price.

Conversion price is fixed when the bond is issued. So, lower dilution of the

company stocks.


How does it benefit an investor?

It’s not just companies who are benefited with FCCB. Investors too enjoy its

benefits. Here are some:

• Safety of guaranteed payments on the bond.

• Can take advantage of any large price appreciation in the company’s stock.

• Redeemable at maturity if not converted.

• Easily marketable as investors enjoys option of conversion in to equity if

resulting

to capital appreciation.

Are there any disadvantages to the investors and companies?

Yes. Like any financial instruments, FCCBs also have there disadvantages.

Some of these are:

• Exchange risk is more in FCCBs as interest on bond would be payable in foreign

currency. Thus companies with low debt equity ratios, large forex earnings

potential only opted for FCCBs.

• FCCBs means creation of more debt and a FOREX outgo in terms of interest

which is in foreign exchange.

• In case of convertible bond the interest rate is low (around 3 to 4%) but there is

exchange risk on interest as well as principal if the bonds are not converted in

toequity


• If the stock price plummets, investors will not go for conversion but redemption.

So, companies have to refinance to fulfil the redemption promise which can hit

earnings

• It will remain as debt in the balance sheet until conversion.

How is taxation done on FCCBs?

Taxation is computed in the following way:

• Until the conversion option is exercised, all the interest payments on the bonds, is

subject to deduction of tax at source at the rate of 10%.

• Tax exercised on dividend on the converted portion of the bond is subject to

deduction of tax at source at the rate of 10%.

• If Foreign Currency Convertible Bonds ( FCCB ) is converted into shares it will

not give rise to any capital gains liable to income-tax in India.

• If Foreign Currency Convertible Bonds (FCCB) is transferred by a non-resident

investor to another non-resident investor it shall not give rise to any capital gains

liable to tax in India.


What is the criteria for issuing FCCBs?

Any company who wish to raise the foreign funds by issuing FCCB,

require prior permission of the Department of Economic Affairs,

Ministry of Finance, Government of India.

The company issuing the FCCB should have the consistent track

record for a minimum period of three years.

The Foreign Currency Convertible Bonds shall be denominated in any

freely convertible foreign currency and the ordinary shares of an

issuing company shall be denominated in Indian rupees.

The issuing company should deliver the ordinary shares or bonds to

a Domestic Custodian Bank as per regulation. The custodian bank on

the other hand instructs the Overseas Depositary Bank to issue Global

Depositary Receipt or Certificate to non-resident investors against the

shares or bonds held by the Domestic Custodian Bank.

The provisions of any law with regard to the issue of capital by an

Indian company will also be applicable the issue of Foreign Currency

Convertible Bonds or the ordinary shares of an issuing company. The

company issuing FCCB, shall obtain the necessary permission or

exemption from the appropriate authority under the relevant law

relating to issue of capital.


Why do companies issue FCCB’s when they are several methods around to

raise money?

Companies have following advantages if they raise the money by issuing FCCB.

1) It is a low cost debt as the interest rates given to FCC Bonds are normally 30-50

percent lower than the market rate because of its equity component.

2) Conversion of bonds into stocks takes place at a premium price to market price.

Conversion price is fixed when the bond is issued. So, lower dilution of the

company stocks.

3) Simple regulatory process.

4) Investors are mostly non-residents or hedge fund arbitrators.

5) Mostly FCCB’s are issued to suit the company needs. If the benefits exist only

for the company, then of course the term FCCB would not even have existed by

now. There are benefits for the investors as well and here are few.

What is in it for Investors?

1) Like any other debt instrument, capital protection by guaranteed payments to the

bond.

2) Greater return potential if the stock price appreciates more than the previously

fixed conversion price.

3) Redeemable at maturity if not converted.

Even though both issuers and investors have advantages, there are some

disadvantages as well in raising money through FCCB. What are they?


Limitations:

1) FCC Bonds are ideal for the bull market scenario as the conversion occurs at a

premium price lowering the dilution. But if the stock price plummet like what we

are

witnessing right now due to the economic downturn, then investors will not go for

conversion and they go for redemption at maturity value. So, companies have to

refinance to fulfill the redemption promise and refinancing is not that easy

particularly in

times like this with lot of credit crunch. Earnings will get hit because of the

redemptions.

2) If the investors do not go for conversion, then companies will be forced to lower

theconversion price (Previously Fixed) to entice the investors to go for conversion

whichwill lead to higher dilution.

3) It will remain as debt in the balance sheet until conversion.

4) If the exchange rate goes up, then the issuer has to pay more to the investors. So,

foreign exchange plays a role too.

5) If the stock price goes below the conversion price, then the issuer loses an

opportunity to dilute at a higher price


Foreign Currency Convertible Bond Policy in India

Ministry of Finance government of India defines FCCB. According to it:

"Foreign Currency Convertible Bonds" means bonds issued in

accordance with this scheme and subscribed by a non- resident in

foreign currency and convertible into ordinary shares of the issuing

company in any manner, either in whole, or in part, on the basis of

any equity related warrants attached to debt instruments; "

Limits of foreign investment in the issuing company.

The Ordinary shares and Foreign Currency Convertible Bonds (FCCB)that are

issued against the Global Depository Receipts are treated asForeign Direct

Investment (FDI). However total foreign investmentmade either directly or

indirectly shall not exceed 51% of the issuedand subscribed capital of the issuing

company.

Taxation on Foreign Currency Convertible Bonds.

Until the conversion option is exercised, all the interest payments on the bonds,

is subject to deduction of tax at source at the rate of tenper cent.

Tax exercised on dividend on the converted portion of the bond is

subject to deduction of tax at source at the rate of ten per cent.

If Foreign Currency Convertible Bonds ( FCCB ) is converted into

shares it will not give rise to any capital gains liable to income- tax in

India.


If Foreign Currency Convertible Bonds (FCCB) is transferred by a

non-resident investor to another non-resident investor it shall not give

rise to any capital gains liable to tax in India.

.


FCCB’s

Foreign Currency Convertible Bonds (FCCBs) have been in the news for most part

of this year, thanks to the global financial turmoil. First, FCCBs were a problem

due to the mounting forex losses of Indian companies.

In addition to the marked to market losses on derivatives, companies also had to

provision for interest costs on FCCBs, following the sharp depreciation of the

Indian rupee.

Later, the problem of high conversion prices for outstanding FCCBs made its

presence felt amid falling stock prices, underscoring the possibility of their non-

conversion. It again made headlines recently, when the RBI allowed the buyback

of FCCBs. But before we begin to track these developments, let’s get the basics

right.

Brass Tacks

FCCB is an instrument that has the features of both equity and debt. Issued as

interest bearing or zero coupon bonds, FCCBs are convertible during their tenure

into equity. They are a popular source of raising money as it benefits both the

investors and issuers.

For investors, it brings the advantage of capital protection (like an investment in

any other debt instrument), as well as the chance to capitalise on an appreciation in

the price of the company’s shares through conversion. For the company, it is a

source of low-cost debt as coupon rates on the bond are lower than the average

lending rates.


Tough times

In the past few years of strong economic growth, rising share prices and lower

interest rates, Indian companies resorted to funding their growth plans through

FCCBs in large numbers. But the current liquidity crunch and the market

meltdown have taken the wind out of their sails.

Companies with FCCBs maturing in the next one or two years are now in a tight

spot, especially so for companies whose stock prices have fallen way below the

conversion prices originally fixed. Take the case of Tata Motors. For 11,760

million yen worth FCCBs maturing in March 2011, the conversion price has been

set at Rs 1,001. But the stock currently trades at Rs 179.

Several other companies such as Subex Azure, Suzlon Energy, Tata Steel,

Wockhardt, Ranbaxy and Reliance Communications are also faced with a similar

problem.

Double-edged sword

In these troubled times, FCCBs have turned out to be a double whammy. That is

because if bondholders do not convert, these companies will be forced to pay up

their liabilities. For example, FCCB holders of Coimbatore-based Shanthi Gears

exercised the redemption option in November, following which the company had

to redeem outstanding FCCBs worth $5.3 million (Rs 25 crore)

In the current cash crunch scenario, small and medium-sized companies may find it

challenging to raise funds to meet this additional liability. Besides, a higher debt


obligation at a time when the economy is already witnessing a slowdown may be a

further drag on their profits.

That said, even if companies choose to lower the conversion price instead of taking

on this burden, their woes may continue as it will then imply a higher equity

dilution than planned.

This notwithstanding, some companies such as Simbhaoli Sugars, Pioneer

Embroideries and Spice Jet have lowered their conversion prices in the past few

months.

Time running out

While companies whose FCCBs mature two-three years down the line can expect

the markets to rebound, others such as Wockhardt, whose FCCBs worth $110

million (Rs 517 crore) mature in October 2009 do not have the luxury of time.Its

shares now trade at Rs 104 as against its FCCB conversion price of Rs 486,

virtually ruling out the possibility of conversion.Any additional borrowing too

might not be a very good option as its debt-equity ratio, currently at about 2.3:1, is

already on the high side. The company is reportedly looking to sell off some of its

non-operational assets to meet its liability.

Realising the catch 22 situation that some of the Indian companies were in, the RBI

had permitted the buyback of FCCBs, (on satisfying certain conditions) last month

through new ECBs (External commercial borrowings).It recently allowed buyback

through rupee resources as well. Reliance Communications, which had issued

zero-coupon FCCBs in February 2007 for $1 billion (Rs 4,700 crore), at a

conversion price of Rs 661 is the first company to avail of this. GTL Infrastructure

too has followed suit.


Buyback of FCCBs

M. R. Rajaram

Of late there have news reports on various developments relating to Foreign

Currency Convertible Bonds (FCCBs). It was only in the late 1990s various

corporations started leveraging FCCBs to fund their growth plans.

It is an efficient method of funding, as an FCCB enjoys the general advantage of

any convertible instrument. It has the right smoothing effect on the EPS when used

for funding a new project or an expansion. Generally the conversion to equity takes

p lace after completion of the project for which the funds are raised through the

FCCB route. The servicing cost of an FCCB till its conversion is capitalised and

hence does not affect the EPS. Post conversion, the earning from the project should

more than offset the dilution in EPS due to the expansion of the equity base. Also

FCCBs, till they are converted to equity, have the advantage of lower servicing

cost applicable for foreign currency loan.

Equilibrium upset

At the same time it also provides an opportunity to leverage the higher PE multiple

in the overseas market, which we had seen till the recent meltdown of the global

economy. Hence FCCB was a very attractive method of financing.

But the steep fall in share prices together with tight liquidity in the global market

has upset the equilibrium, placing both investors and companies in difficulty. The

conversion prices for most of the FCCBs were agreed upon years back when the

market was experiencing a bull-run. As a result of the steep fall in share prices, the


RBI eases norms

The earlier relaxation permitted buyback only when the issuing company funded

this requirement through new ECBs. This has very little benefit as in today’s

global financial market it is almost impossible for companies to raise fresh ECBs

to fund the buyback of FCCB.

The new set of guidelines issued by the RBI on December 6, 2008, addresses this

difficulty to a certain extent. Now the requirement can be funded using rupees. The

foreign currency required to purchase the FCCB can be obtained from the RBI.

However this facility is available only when the company is able to buy the FCCB

at a discount equal to or more than 25 per cent. One could argue that though the

threshold level of 25 per cent discount is arbitrary it is a right step in terms of

effective use of the forex reserves.


Internal accruals

However the RBI should seriously reconsider the other condition, namely, that the

buyback has to be funded from internal accruals only. This is a stringent condition

to meet, as internal accrual will not include share capital or premium on issue of

shares. Thus to meet this condition, the total borrowings, including the money

required for buyback, should be less than the retained earnings of the company.

This effectively means a debt-equity ratio of less than one. By any standard such a

low gearing as a precondition is not justified. Even under the Companies Act, for

permitting the buyback of shares the maximum debt-equity ratio allowed is 2:1.

The RBI should reconsider this requirement and bring this precondition in line

with Companies Act regulation for buyback of shares. Else, many companies will

not be able utilise this opportunity.

(The author is Director, ICI India Ltd. [email protected])


New guidelines announced; prepayment window open till March 2009.

Foreign convertible bonds buyback with rupee resources allowed

New Delhi, Dec. 6 Indian companies can now pre-pay their existing foreign

currency convertible bonds (FCCBs) from their rupee resources in addition to their

foreign currency accruals.

The guidelines for pre-payment/buyback of FCCBs by Indian companies, issued by

the Finance Ministry here on Saturday, coincided with the Reserve Bank of India

Governor, Dr D. Subbarao’s announcement in Mumbai of growth stimulus

measures.

Dr Subbarao said the RBI would now consider applications for buyback of FCCBs

out of rupee resources of companies. The central bank had in mid-November

invited proposals for premature buyback of FCCBs under the approval route so

long as it was financed out of foreign currency resources held in India or abroad

and/or out of fresh external commercial borrowings (ECBs).

This is the first time ever a buyback scheme had been framed by the Government

for FCCBs, say experts in financial services industry, who see this move as another

effort of the Government to placate the Indian corporate sector that had been badly

hit by the global financial meltdown.

The Finance Ministry has in its guidelines specified that the provision of pre-

payment (premature purchase) of existing FCCBs would be available up to March

31, 2009. Also, the existing condition of minimum maturity period for redemption

of bonds has been put on hold till March 31, 2009.


It has also been specified that the initiation power/right of pre-payment was vested

with the issuer of bonds and not with the holder of bonds. However, the actual pre-

payment would be subject to the consent of the bondholder. Also, the bonds

purchased from the holders must be cancelled and should not be re-issued or re-

sold.

For buyback allowed under the automatic route out of foreign currency funds

raised through fresh ECBs, it has been stipulated that the all-in-cost ceiling should

not exceed 6 months LIBOR plus 200 basis points, if the fresh ECBs are co-

terminus with the residual maturity of the original FCCBs but is less than three

years. Also, there should be a minimum discount of 15 per cent on the book value.

In the case of approval route, Indian companies can buyback out of rupee

resources, representing internal accruals, so long as the amount does not exceed $

50 million of the redemption value of the FCCB per company and a minimum

discount of 25 per cent on the book value.

“This is too little, too late and more of a signal to corporate sector, with an eye on

the elections. The challenge is to get bigger volumes and more transactions under

this prepayment window. I don’t see very many institutional players relinquishing

their rights under the bonds at a discount”, Mr Apurva Mehta, Director (Financial

Services), KPMG, told Business Line.


The redemption millstone - S. Murlidharan

Foreign currency convertible bonds (FCCBs) have been hugely popular with

Indian corporates as a source of capital mobilisation. And they have been lapped

up by foreign investors wanting to test the waters first before committing

themselves to the uncertain, yet hugely rewarding, world of equity.

Cheap funds

An FCCB has all the trappings of a convertible debenture; only it is denominated

in a foreign currency. Till conversion, which is entirely optional, companies get to

enjoy some cheap funds given the fact that the interest rates in the US and

European markets have always been low vis-À-vis the Indian rates of interest.

What beckons the foreign investors is the promise of acquiring shares at a

discount vis-À-vis the ruling market price. But unfortunately for many Indian

companies, the inexorable decline in their fortunes in the Indian bourses has spelt

non-exercise of the conversion option by the foreign investors resulting in a huge

redemption liability staring at them in the near future for which they were not

obviously prepared punch drunk as they were with confidence that such an

eventuality would never arise.

Markets however have the ability to humble anyone, including the high and mighty

as well as those who are blasé.


In a bind

These companies are now at their wits’ end. First, how to pay back the foreign

investors when the redemption time arrives? Second, Section 117C of the

Companies Act mandates them to create reserve out of profits so as to be able to

redeem the debentures out of such accumulated profits. And, third, user charges for

these funds have not been provided for in the accounts, thus giving a bloated and

exaggerated figure of profits.

The first predicament of these companies is not the subject of this article. The

second and the third are. The reason trotted out as to why these companies did not

provide for user charges and did not create a redemption reserve is simple — never

in their wildest dreams did they foresee the possibility of investors not exercising

their conversion option.

The Ministry of Company Affairs (MCA) stand is that reserve under Section 117C

is to be created only on the non-convertible portion of the bonds or debentures. In

fact, this has come handy for companies which say that they did not know how

much is redeemable so as to be in a position to create a reserve, anticipating as they

did 100 per cent exercise of conversion option.

And the same we-lived-in-fools-paradise theory has been extended for not

providing for user charges that has had the effect all these years of considerably

overstating their profits.Foreign investors have often complained of lax regulatory

framework as an inhibiting factor. The FCCB accounting fiasco is a telling

example of this.Unfortunately, AS-31 is some distant away, taking as it does

mandatory effect only from the year 2011.


Notify standard

But it does throw some valuable light on the issue to the benighted corporates:

“The company’s contractual liability to make future payments remain outstanding

until it is extinguished through conversion ….”

Simply put, what the standard says is a company has no business or need to

second-guess the minds of the investors — till they exercise their conversion

option, the FCCB very much remains a debt instrument.

The ICAI has, in fact, hit the nail on the head. But its standard, sound as it is, has

had no applicability to accounts prepared all these years. Shouldn’t the MCA try to

steal a march over the ICAI for a noble cause and notify this standard under the

Companies Act with immediate effect?

(The author is a Delhi-based chartered accountant.)


FCCB redemptions put India Inc in a Catch 22 situation - Arun Kumar / New

Delhi October 3, 2008, 0:55

Indian companies that raised large sums of foreign funds to finance growth and

acquisition plans during the bull run in the stock markets are in a Catch 22

situation. The conversion price of their foreign currency convertible bonds is

several times higher than their current market prices.

This leaves them with two options. One is to reset the price at current market price,

a move that could dilute promoter holdings (since it would entail issuing more

equity shares). The other is to redeem the bonds, which could increase debt

obligations that are already substantial in some cases.

The maturity of many of the FCCBs is expected to start in October 2009 and peak

in 2010-11. Most analysts say the market is unlikely to recover so significantly

over the next two years that market prices will match the conversion prices.

In some cases, the outstanding amount on account of FCCBs is higher than or

around the current market capitalisation of the companies concerned (see table).

For instance, Hyderabad-based Subex Auzure raised $180 million (Rs 846 crore)

in 2007 to finance the acquisition of Azure. The company’s market capitalisation

as of September 30 was Rs 298 crore.

Should the management decide to re-set the conversion price and link it to the

current market price, the company’s equity would be diluted. If it decides to repay

these bonds, the redemption amount with interest would be around Rs 1,150 crore.

The company has already raised debt of around Rs 1,050 crore.


The $110 million FCCB raised by pharmaceutical major Wockhardt is slated for

conversion in October 2009 at Rs 629.80 against a current price of around Rs 155.

If the company chooses to redeem the bonds, it will have to pay $140 million or Rs

658 crore. The company already has a debt obligation of around Rs 3,000

crore.Firstsource, which is being put on the block by its promoters ICICI Bank,

had mopped up $275 million through FCCBs, for which the conversion rate is Rs

128.60 against its current share price of around Rs 28.Comments WelcomePricing

inflation-indexed and foreign-currency linked convertible bonds with credit

riskYoram LandskronerSchool of Business Administration Hebrew University of

Jerusalem, Israel and Stern School of Business, New York University New York,

NY 10012, U.S.A. Email: [email protected] RavivSchool of Business

Administration Hebrew University of Jerusalem, Israel Email:

[email protected]

March 10, 2003

JEL classification: G12, G13 Keywords: convertible bonds, credit spread, binomial

tree, pricing, inflation.

This paper was written while we were visiting the Stern School of Business. We

are grateful for the hospitality that we received at this institution. Landskroner

acknowledges the financial support of the Krueger Foundation of the Hebrew

University of Jerusalem. Raviv acknowledges the financial support of Shtesel Fund

at the Hebrew University of Jerusalem. We received valuable comments from

Menachem Brenner, Dan Galai, Dan Volberg, Zvi Wiener, and seminar

participants at the Hebrew University of Jerusalem.


Pricing inflation-indexed and foreign-currency linked convertible bonds with

credit risk

Issuing convertible bonds has become a popular way of raising capital by

corporations in the last few years. An important subgroup is convertibles linked to

a price index or exchange rate. The valuation model of inflation-indexed (or

equivalently foreign-currency) convertible bonds derived in this paper considers

two sources of uncertainty allowing both the underlying stock and the consumer-

price-index to be stochastic and incorporates credit risk in the analysis. We

approximate the pricing equations by using a Rubinstein (1994) three-dimensional

binomial tree, and we describe the numerical solution. The proposed model

includes several well-known models as special cases, like Margrabe (1978) and

McConnell and Schwartz (1986) and others. We investigate the sensitivity of the

theoretical values with respect to the characteristics of the issuer, the economic

environment and the security’s characteristics (number of principal payments).


In this section, we develop a valuation algorithm for the pricing of inflation

indexed convertible bonds. Unlike a nominal convertible bond that pays known

coupons and principal payments the coupon and the principal payments of the

inflation indexed convertible bond are linked to the changes of the consumer-price-

index (CPI) during the life of the convertible bond.

In order to price this type of convertible the following assumptions are made10:

(1) Investors can trade continuously in a complete, frictionless, arbitrage-free

financial market. In particular it is assumed that there are no transaction costs, no

restriction on short selling, and no differential taxes on coupons versus capital

gains income.

(2) The uncertainty in the economy is characterized by a probability space (Ω, F ,

Ρ) , where Ω is a state space, F is the set of possible events and Ρ is the objective

martingale probability measure on (Ω, F ) . The stock price S follows the stochastic


Conclusion

India Inc has been using the FCCB window as a major finance-raising tool for

meeting its capes requirement at competitive rates and the present regulatory

regime has fully supported the Industry efforts to meet its financing needs.

The quality of Indian paper has also gained widespread International acceptability

and is expected tofurther momentum in coming years. The Industry needs to ensure

that faith and trust of Government and regulators are upheld particularly in view of

emphasis of the Government to curb money laundering

FCCB is a good source of raising funds with minimum cost. The procedural aspect

is comparatively simple. The company can raise loan without creating security on

assets. That is why most of the companies are opting to go for FCCB, though the

exchange risk is there


BIBLIOGRAPHY

http://www.articlesbase.com/regulatory-compliance-articles/foreign-currency-

convertible-bonds-in-india-2678834.html#ixzz18fV96FcE

http://indiacorplaw.blogspot.com/2010/02/pricing-adjustments-for-fccbs.html

http://www.crisil.com/Ratings/Brochureware/News/CRISIL-Research-fccb-

pr_230511.pdf?cn=null

http://www.rbi.org.in/scripts/FAQView.aspx?Id=26

http://www.investopedia.com/terms/f/fccb.asp

http://www.moneycontrol.com/news/business/6-month-window-to-change-fccb-

conversion-price_441919.html

http://www.moneycontrol.com/news/business/6-month-window-to-change-fccb-conversion-price_441919.html

http://www.moneycontrol.com/news/business/6-month-window-to-change-fccb-conversion-price_441919.html

http://www.investopedia.com/terms/f/fccb.asp

http://www.rbi.org.in/scripts/FAQView.aspx?Id=26

http://www.crisil.com/Ratings/Brochureware/News/CRISIL-Research-fccb-pr_230511.pdf?cn=null

http://www.crisil.com/Ratings/Brochureware/News/CRISIL-Research-fccb-pr_230511.pdf?cn=null

http://indiacorplaw.blogspot.com/2010/02/pricing-adjustments-for-fccbs.html

http://www.articlesbase.com/regulatory-compliance-articles/foreign-currency-convertible-bonds-in-india-2678834.html#ixzz18fV96FcE

http://www.articlesbase.com/regulatory-compliance-articles/foreign-currency-convertible-bonds-in-india-2678834.html#ixzz18fV96FcE

Foreign Currency Convertible Bond 100 marks project

Documents

Transcript of Foreign Currency Convertible Bond 100 marks project