MeltDown in Indian Market pulls Current Prices below Conversion Prices

The meltdown in the Indian stock market this year, induced by global bearishness following the subprime crisis in the US, has resulted in pulling down the current market price of the shares of some Indian FCCB issuers way below the bonds’ conversion price.

FCCBs are debt instruments, issued normally in dollars, with an option to convert them to equity at a pre-determined price. The convertible bonds, which help companies raise foreign currency funds at attractive rates, have largely been zero-coupon bonds, where the interest payment is due on the maturity of the bonds. As a result, there is no cash outflow from the issuing company either towards interest payments or for repayment of principal.

FCCBs are usually priced at a premium of 30-70% over the prevailing market price of the share and the option holder converts the bonds to equity if the stock price exceeds the conversion price. If the market price of the stock does not exceed the option price, the holders will not opt for equity conversion and the issuer will have to redeem the debt.

Although these instruments are treated as debt on the balance sheet, the assumption at the time of issue is clearly that the bonds will get converted into equity and no payments need be made by the issuer towards redemption. In fact, corporations usually do not even show the pro-rata interest charge on account of FCCBs in their profit and loss statement. FCCB holders normally convert their holdings when a company’s shares are trading at a hefty premium to the conversion price. Else, they prefer to hold on to the bonds till maturity and earn interest income, which would be about 35% of the original investment for a bond with a 6% yield and a five-year tenure. It’s only when they are assured that the return on the shares will be much higher than the interest earned on the bonds, that they convert FCCBs into equity.

Some of these issuers could be in a difficult situation as they may not be capable of raising additional debt to repay FCCB holders (if the bonds are not converted). Some companies, then, could even collapse under the weight of their outstanding debt.