With around Rs 14,000 crore worth of foreign currency convertible bonds (FCCBs) falling due

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for redemption in 2011, inve­stors will keep a close watch on companies’ ability to weather the stress on balance sheets.

In most cases, present stock prices and the pre-decided conversion prices (which are mostly higher) are not at same levels, making it a loss-making proposition for bondholders to convert bonds into proportionate equity.

Driven by these options, most companies with FCCBs are likely to be compelled to either get the bonds refinanced (at higher interest rates given the current macro-environment) or repay bondholders in cash, if they have the necessary resources.

For instance, Ranbaxy had issued $440 million FCCBs at zero per cent interest rate, but with a yield to maturity of nearly 5 per cent. While the revised conversion price of these bonds stands at Rs 546 a share (excluding taxes), the share is at Rs 460. Company officials have indicated that it will repay $550 million to overseas investors, who hold bonds convertible into equity, by using cash and possible domestic debt lines.

Other companies such as India Cements, Punj Lloyd and Hindustan Construction Company did not make adequate interest provisions on the FCCB debt to income statements and, naturally, their historical profits were higher. Market experts said many companies with FCCB issuances actually expected stock prices to go up five years ago and they will now have to resort to rear-guard action.

According to veteran fund manager Sankar Naren, who oversees an equity portfolio worth $5 billion at ICICI Prudential Mutual Fund, investors need to divide companies in two clear sets. “There are companies which can virtually go bankrupt when FCCBs rear the ugly head and you have another set of companies which have resolved this issue. In our portfolio, there was a textile company with a FCCB problem. However, it did a QIP to raise cash, so that took care of the problem.”

Hindustan Construction Company hasn’t been able to solve its FCCB problem. The present stock price reflects a situation that can be ascribed to a valuation discount (10-30 per cent) compared with its peers.

According to Lavina Quadros and Rajarshi Maitra of Enam Securities, the conversion is unlikely when they come up for redemption in April, given the current stock price of Rs 34-35 while the conversion price is Rs 123. The redemption amount will be close to Rs 600 crore, and this may mean use of cash and incremental debt in 50:50 proportions.

Investors looking at these companies over the next four to six months should gauge the impact of this factors first. With stock prices of key companies (with upcoming FCCB redemptions) already down 10 to 40 per cent over the past three months, prices have become attractive. This is why experts are asking investors to be cautious.

“There can either be a substantial cash outflow from the company if bonds are repaid, while restructuring of these bonds may lead to greater equity dilution. If the impact is not going to be substantial, only then fresh investment makes sense,” says Dipen Shah, senior vice-president (private client group – research) at Kotak Securities.

Aurobindo Pharma, which has a tranche of FCCBs up for redemption in May, is likely to repay the debt from the recently raised ECB of $125 million and by tapping internal accruals. Jubilant Life Sciences is likely to see a higher cost of debt (as it has tied up funds at 7 per cent per annum versus 5 per cent earlier) on its profit and loss account.

Restructuring of bonds is important as the revised agreement may lead to more shares being given out to bondholders. The extra shares (say 8 per cent) will add to outstanding shares of the company and will reduce earnings per share by the same extent if profit remains stagnant.

Kotak Securities’ Shah felt companies where stock prices are near to or higher than conversion price, FCCB conversions will happen. However, there will be an increase in liquidity post-conversion. So in the short term, these stocks may remain under pressure. This is something investors should keep in mind, he added.

Another point to ponder upon is the historical impact of FCCB debt.

“If a company has managed to raise cash, sell off assets to tide over the FCCB crisis or revise agreements with FCCB holders, that’s good news. But investors should keep a tab on the use of FCCB funds. If they were used effectively for expansion purposes, do not balk at equity expansion (on conversion) as earnings expansion would have happened. But if earnings have not risen, that gives you a signal that the money was not used well,” said Alex Mathews, head of research at Geojit BNP Paribas Financial Services.

Compounding the problems for companies facing FCCB redemptions could be the sticky accounting standards for FCCBs. Tax experts point out that under existing Indian accounting standards, FCCBs are treated as debt instruments, and any interest rate that a bond issuer paid to a bondholder on an FCCB is charged to the income statement. Most companies charge redemption premium to the securities premium account on the maturity of the FCCB.

However under the IFRS, an FCCB will be split into a debt instrument that will accrue a fair interest charge annually; while the conversion option will be valued separately and marked to market. Under IFRS, reported profit will thus be lower and more volatile.

kumarsroy@mydigitalfc.com