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You might be considering P/E Ratio, Debt to Equity Ratio, PEG Ratio etc before you consider any stock for investments, you might include one more factor which can make your filter more effective and that is Foreign Currency Convertible Bond (FCCB) outstanding. ‘Bond’ sounds a bit boring but trust me this one is interesting.
What is Foreign Currency Convertible Bond (FCCB)?
Large multinational companies like Bharti Airtel, FSL etc with offices around the world may also decide to raise money outside its home country to gain access to new markets for new or expansionary projects. FCCBs are simple bonds (In a currency different than the issuer’s domestic currency) issued by listed companies in the overseas market. FCCBs pay interest at a nominal rate and usually carry clauses which allow the issuer or bondholder the option to convert the bonds into shares mid-way during its term, at a pre-agreed price.
These convertible bonds have a conversion rate at which the bonds will be converted to equity. However, if the stock price stays below the conversion price, the bond will not be converted.
Why Its a Win-Win Situation:
Foreign investors buy FCCBs because, apart from earning a fixed interest, they get an option to convert those bonds into shares at a fixed price, pocketing a quick gain as a result. Conversion prices will usually set at a premium to current market prices, as it was assumed that the stock price would continue to rise.
Issuing Companies consider this as ‘free money’ which might not have to be repaid as the bonds would inevitably get converted into equity.
Due to the equity side of the bond, which adds value, the coupon payments on the bond are lower for the issuer than a straight coupon-bearing plain vanilla bond, thereby, reducing its debt-financing costs. In addition, a favorable move in the exchange rates can reduce the issuer’s cost of debt, which is the interest payment made on bonds.
Risks and Shortcomings:
Since the principal has to be repaid at maturity, any adverse movement in exchange rates in which the local currency weakens can cause cash outflows on repayment to be higher than any savings in interest rates, resulting in losses for the issuer. In addition, issuing bonds in a foreign currency exposes the issuer to any political, economic, and legal risks prevalent in the country. Furthermore, if the issuer’s stock price declines below the conversion price, FCCB investors will not convert their bonds to equity, which means the issuer will have to make the principal repayments at maturity.
If the stock price crashes say by 50-70% then bondholders will have no inclination to convert their loans into shares. The borrowing firms will be saddled with large foreign currency loans they were badly placed to repay.
To get out of this hole, in 2008, many of them used a ‘reset’ option and slashed their FCCB conversion prices to make it attractive for holders to convert. But this also meant much larger equity dilution for their Indian shareholders, as more shares had to be issued to match the debt.
Like a few days back a news flashed that:
Now you understand.
Why Investor should care?
If a company carries FCCBs on its books, you will have to keep an eagle eye on how it meets its FCCB obligation.
Non-conversion of FCCBs can pose a risk to investors too. As FCCBs are dollar denominated, a depreciating rupee can bloat these loan obligations.
In nutshell, A company which carries large FCCBs in their books also carries two big risks:
- Currency Risk
- Liquidity Risk
So, next time, be more selective while ‘stock picking’.
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