The Reserve Bank of India (RBI) announced on November 15, 2008, that it would consider proposals from Indian companies for early redemption of Foreign Currency Convertible Bonds (FCCBs) issued by such companies.

The RBI noted that FCCBs issued by Indian corporates are currently trading at a discount and that it may be beneficial to such companies as well as the Indian economy if these corporates bought back their FCCBs at prevailing discounted rates.

Such buy backs would be required to be financed by the companies’ foreign currency resources held in India or abroad or out of fresh foreign currency borrowing (ECB) by such companies in conformity with the RBI’s guidelines on ECB.

The RBI’s announcement follows successive Government of India (GoI) measures this year to free up credit and mitigate the impact of the global financial crisis, including liberalisation of its ECB policy and the introduction of Foreign Currency Exchangeable Bonds (FCEBs) to allow parent companies to raise additional debt by tapping the value of their equity in group companies. The RBI has also, on November 28, 2008, liberalised the pricing restrictions on FCCB issues.

Overview of FCCBs

  • FCCBs are convertible bonds denominated in foreign currency issued by listed Indian companies outside of India (they typically are registered in Luxembourg or Singapore).
  • FCCBs up to US$500 million can be issued by an Indian company in each financial year for permitted uses without RBI approval (RBI approval would be required for an issue above US$500 million). They are deemed to be foreign direct investment in the issuer, and need to conform to the prescribed sectoral caps under the GoI’s foreign direct investment (FDI) policy.
  • FCCBs should have a minimum maturity of 5 years with no call or put option or prepayment exercisable during this period. Buy back is subject to prior approval of the RBI.
  • FCCB coupon rates are capped: 6 month LIBOR plus 300 bps (for 3 – 5 year FCCBs); 6 month LIBOR plus 500 bps (for FCCBs above 5 years).
  • Conversion is not mandatory and the conversion price is subject to a floor geared to the average trading price of the issuer in India for a 2-week period prior to issuance.
  • FCCBs can be issued publicly (through reputable lead managers) in the international capital markets or placed privately with banks, multilateral and bilateral financial institutions, foreign collaborators or foreign equity holders (holding a minimum of 5 percent), and may be used for specified purposes such as import of capital goods and investments in the infrastructure sector, but investments in stock markets and real estate are not permitted.
  • FCCBS have been popular with large corporates in recent years, particularly for large, capital intensive projects that matched the conservative term and tenor requirements of the RBI relative to INR borrowing prices in India. FCCBs typically have had very low—even zero coupon—rates.

Conversion of FCCBs

  • The expectation among Indian issuers has typically been that lenders would convert FCCBs to equity prior to maturity rather than seek redemption given the persistent bull run of the Indian markets. As a result, many issuers neither expected nor made provision for redemption of their FCCBs. Bondholders may have remedies available to them where FCCBs have been issued without complying with all legal requirements, such as creation of appropriate redemption reserves.
  • In the current market environment, declining valuations and a weakening INR have made conversion an unattractive option for lenders as the great majority of issuers are trading at substantial discounts to the conversion price—the bonds are “under water.”
  • An alternative available to issuers is to renegotiate the conversion price. If pricing could be negotiated closer to present levels, however, it would result in greater dilution of existing equity holders, including promoters and founders, and it is not clear that FCCB holders would be keen to be in the equity in this environment even at lower prices.

Redemption

  • As conversion of maturing FCCBs appears unlikely, there is now a huge impending redemption liability for many issuing Indian companies (beginning in 2009, and peaking in 2010 – 2011) as there often is a redemption premium (reflecting the yield-to-maturity) payable if an FCCB is not converted prior to maturity.
  • In addition to a substantial redemption payout, holding the bonds to maturity also would force Indian companies to account for their FCCBs as debt, which they typically do not do (again, in anticipation of full conversion prior to final maturity) and would erode corporate profits considerably.

Buy Back

  • It is unclear whether Indian issuers have the foreign exchange required to buy back outstanding FCCBs prior to maturity even if permitted to do so. Financing buy backs or redemptions through fresh foreign currency borrowing is likely to be very difficult in the current market environment, particularly given the term and tenor requirements applicable to foreign currency lending into India.
  • In addition, there are corporate, tax and securities law issues in India associated with any such buy back of public debt. Further, based on the jurisdiction where the FCCBs are listed and where FCCB holders are based, a number of securities law and other issues particular to that jurisdiction may also need to be considered in connection with any FCCB buy back.
  • It is also not clear what criteria the RBI will use in granting its approval for buy back.

Conclusion

Greater flexibility likely will be required to address the likelihood of large-scale defaults in coming years. If the RBI continues to react in a progressive manner, there may be significant opportunities for foreign lenders and investors to participate in restructuring and to invest in relatively healthy Indian corporates at near distressed level.