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Foreign Currency Convertible Bonds (FCCB)

Bonds that are issued in a currency foreign to the issuer

What are Foreign Currency Convertible Bonds (FCCB)?

Foreign currency convertible bonds, as the name suggests, are bonds that are issued in a currency foreign to the investor. The name also suggests that the bonds are convertible in nature, indicating that investors not only receive principal and coupon payments but also offer the option of converting their bonds into stocks.

 

Foreign Currency Convertible Bonds (FCCB)

 

Characteristics of Foreign Currency Convertible Bonds

Foreign currency convertible bonds are classified as quasi-debt instruments. They allow both the investor and the corporation issuing bonds to share risk and reward. Investors take on risk by putting faith in the corporation doing well financially, while companies are able to raise money in different currencies to finance their operations.

Understanding how a foreign currency convertible bond works requires an understanding of the same fundamentals for regular bonds. However, the option of converting the bond to stocks is the aspect that makes FCCBs unique.

  • The money raised from the bond issue by the issuing company is in a foreign currency, as well as the principal amount and coupon payments.
  • At maturity, investors are to be paid the entire face value of the bond. The term of foreign currency convertible bonds generally tends to be around five years.
  • The issuer is able to convert the bond into stock at a pre-determined conversion rate at which the issuer is granted a certain number of shares.
  • If the bond is issued with a put option, the investor has the authority or right to redeem when they want to convert their bond to stocks. If the bond is issued with a call option, then the issuing company holds the right to redemption.

 

Benefits of FCCBs

 

To the company issuing foreign currency convertible bonds:

  • The coupon rates on FCCB’s are generally lower than traditional bank interest rates, reducing the cost of debt financing.
  • If converted, the company is able to reduce its debt as a result of foreign currency convertible bonds and thus gains additional, much-needed equity capital.
  • If there is a favorable move in the exchange rate, the company may benefit from a reduction in the cost of debt.

 

To the bondholders:

  • An assured minimum fixed rate of return.
  • Investors can participate in any price appreciation in the issuer’s stock upon conversion.
  • Flexibility in choosing to enter the capital market or receiving a stable stream of income through bond payments (coupons). It is a unique dual advantage of equity and debt that the investor gets through foreign currency convertible bonds.

 

Drawbacks of FCCBs

 

To the company issuing foreign currency convertible bonds:

  • If the stock market is in a negative cycle, the demand for foreign currency convertible bonds decreases.
  • Ownership will be diluted, and earnings per share will decrease with each issuer who decides to convert their bonds into stocks.
  • If the issuing company’s currency does not perform well compared to the bondholder’s domestic currency, the principal and coupon payments will become more costly.
  • It is possible that bondholders choose not to convert at all. This will mean that the issuing company has to pay out the debt and interest in full.

 

To the bondholders:

  • Foreign currency convertible bonds are subject to exchange rate risk and credit risk.
  • The issuing company may bankrupt, following which the repayment of face value at maturity will no longer be plausible.
  • Bondholders have no control over the established conversion rates and prices.

 

Special Cases

Foreign currency convertible bonds provide several advantages and disadvantages to the stakeholders involved, as we saw in the previous section. Although a financial currency convertible bond is a financial instrument that allows sharing of risk between the issuing company and the issuer, there are some situations that are extremely risky and can cause grave financial damage to either and/or both parties involved. Let us consider two such scenarios where external conditions can have a drastic effect.

Scenario 1: In India, the annual limit on foreign currency convertible bonds is $750 million. Considering companies are eligible to give out bonds for such high values, at the time of repayment on maturity, if the exchange rate becomes unfavorable to the rupee, it can cause huge losses for the Indian company that must repay the face value of the bond.

Scenario 2: Another unfortunate situation arises for the issuing company when they rely on a conversion yet have to continue to give out coupon payments in times of high exchange rates. This can also result in a huge cash outflow and doesn’t enable companies to find equity capital. For example, in 2012, India’s leading automaker, Tata, owed almost $623 million in debt, for which it was compelled to borrow further.

 

Learn More

CFI offers the Capital Markets & Securities Analyst (CMSA)® certification program for those looking to take their careers to the next level. To keep learning and advance your career, the following resources will be helpful:

  • Bond Pricing
  • Credit Risk
  • Debt Financing
  • Indian Rupee (INR)

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