Foreign Currency Convertible Bonds: Features & Benefits | 5paisa (2024)

Understanding Foreign Currency Convertible Bonds

Foreign currency convertible bonds are issued in a currency foreign to the investor. You can also understand from the name that these bonds are convertible. Therefore, investors can receive principal and coupon payments while also getting the option to transform their bonds into stocks.

How Foreign Currency Convertible Bonds Works?

Foreign currency convertible bonds are generally issued by major, publicly traded multinational corporations operating all over the world to raise foreign currency capital. These bonds include every trait a convertible bond has. To put it another way, because the corporation issues this bond in a foreign currency, principal and interest payments must be made in that same currency.
Companies can access new markets for expansion when they raise capital outside of their own nation. Businesses usually decide to issue FCCBs in a nation with a cheaper interest rate or one whose economy is more secure than their own. Additionally, because FCCBs are convertible into equity, they have decreased interest rates than standard bonds.
Any unfavorable change in exchange rates can weaken the local currency when the business has to return on maturity. It increases the cash flows upon repayment. The issuing corporation may consequently suffer damages. Furthermore, issuing companies of foreign currency convertible bonds are subject to the different political, economic, and legal risks of the nation.
Investors of FCCBs will not convert their bonds into equity if the company's stock price drops below the conversion price. Upon maturity, the company must make payments. However, investors can participate when the value of the company increases by turning their bonds into equity. When a stock price hits a certain level, they can use active warrants to profit from this appreciation.

Features of Foreign Currency Convertible Bonds

The different features of the foreign currency convertible bonds are as follows:

● FCCBs are similar to convertible securities. They make regular coupons and principal payments in a foreign currency till a particular date. After that, the issuer is allowed to change it into equity.
● These convertible bond offerings come with lower interest rates than standard bonds.
● No security or collateral is necessary for the issuance of FCCBs.
● FCCBs are traded on a foreign stock exchange.
● Since they are equity-linked debt securities, the holder can transfer the bond into equity or depository receipt after some time.
● Companies are allowed to issue bonds using a call or put option. The investor can transform the bonds in the stock into a put option.
● The funds collected through the FCCB will be used according to ECB guidelines.

Benefits of FCCBs

FCCBs have various benefits for the issuing company as well as the bondholder:

To the Company Issuing Foreign Currency Convertible Bonds:

● The coupon rates are usually lower than standard bank interest rates, which minimizes the cost of debt financing.
● If converted, the company can lower its debt and gain equity capital.
● A favorable move in the exchange rate provides the company with a reduction in debt cost.

To the Bondholders:

● A guaranteed minimum fixed rate of return.
● Investors can involve themselves in the price appreciation in the issuer's stock upon conversion.
● A lot of flexibility in deciding to enter the capital market or receive a stable income stream via bond payments.

Drawbacks of FCCBs

Foreign currency convertible bonds also offer some disadvantages to the issuing company and bondholders.

To the Company Issuing Foreign Currency Convertible Bonds:

● The demand for FCCBs reduces when the stock market is in a negative cycle.
● Ownership gets diluted, and earnings per share reduce with every issuer converting the bonds into stocks.
● The principal and coupon payments become expensive when the issuing company does not perform well compared to the domestic currency of the bondholder.
● If the bondholders decide not to convert, the issuing company has to pay the full debt and interest.

To the Bondholders:

● FCCBs are subject to credit risk and exchange rate risk.
● If the issuing company goes bankrupt, the face value repayment at maturity won't be plausible anymore.
● The conversion rates and prices are fixed, and bondholders have no control over them.

RBI Requirement for FCCB

According to a circular by the RBI, Issue of Foreign Currency Convertible Bonds and Ordinary Shares Scheme, 1993, governs the FCCBs. The foreign currency convertible bonds are issued according to the guidelines of the External Commercial Borrowings, which come with the following requirements:

● The maturity of FCCB has to be at least five years.
● In case there is a put or call option, it cannot be executed before five years.
● Companies are not allowed to issue FCCBs without attached warrants.
● The issue-related expenses of FCCBs are not allowed to go above 4% of the issue size.

Redemption of FCCBs

The different terms and conditions associated with the redemption of foreign currency convertible bonds are as follows:

● Issuers are allowed to raise fresh FCCBs within stipulated maturity by following the ECB norms.
● The value of the fresh FCCB cannot be higher than the outstanding maturity value.
● Issuers are not allowed to raise new FCCBs six months before the maturity date of the outstanding FCCBs.
● The FCCB purpose shall be distinct as 'Redemption of Outstanding FCCBs' in Form 83 during the time of RBI registration.
● A designated AD-Category I bank will be responsible for monitoring the fund usage.
● All aspects in relation to the ECB policy, including the lender, borrower, and repayment, must be the same.
● It becomes available under the automatic approval route if the FCCB issue is up to $750 million for refinancing existing outstanding FCCB.
● Special approval from RBI is necessary if the FCCB issue is above $500 for the purpose of redemption.

Tax on Foreign Currency Convertible Bonds

● Until the conversion option gets executed, the interest payments on the bonds are subject to a deduction of up to 10%.
● 10% TDS gets deducted from the conversion portion of the bond.
● If the investor changes the FCCBs into shares, it won't be considered a capital gain.
● When a non-resident investor transfers foreign currency convertible bonds to another non-resident investor, it isn't considered a capital gain.

Special Cases - Foreign Currency Convertible Bonds

In some situations, foreign currency convertible bonds can cause grave financial damage to one or both parties involved. Some special scenarios where external factors can have a major effect are as follows:

Scenario 1

In India, the yearly limit for FCCBs is $750 million. If the exchange rate is unfavorable to the rupee during the time of repayment on maturity, the Indian company ends up facing huge losses.

Scenario 2

If the issuing company relies on conversion but has to keep making payments during times of high exchange rates, it is extremely unfortunate for them. It can lead to a huge cash outflow and prevent companies from finding equity capital.

Conclusion

Any proposal for restructuring FCCBs without involving conversion price changes demands special RBI approval. The policy gets reviewed periodically according to the macroeconomic conditions and various other factors.

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