Jan 102011
 

Ref: 2011-01 of 1 January, 2011 (This is Abridged Web Edition) (eBook version – $9.95 – See sidebar)

 

You have heard about CB or FCCB which is nothing but Convertible Bonds or Foreign Currency Convertible Bonds. Dhirubhai Ambani of India made the CB very popular and made his Reliance empire only from Convertible Bonds. He almost destroyed Birla who promoted and owned MRPL or Mangalore Refinery and Petrochemicals Ltd. , sold it to ONGC for just Rs 2 per share against current market price of Rs 80 or nearly 40 times or 4000% return on investment to ONGC who owns over 80% of the company.

Individuals and Funds must know how to invest into this wonderful hybrid security – Convertible Bonds.The Corporate borrowers like Birla and Tata must learn how to borrow via CB or FCCB route profitably.The history shows that they failed in the past, Most equity investors world over do not know much about investing into CB or FCCB. It is a brilliant art, science and commerce.I made most money for my HNW (High Net Worth) investor clients by focusing on Convertible Bonds almost exclusively.

 

CB usually have following terms:

  1. Amount : Say, Rs 500 crores with Denomination of Rs 5000 each.(Denomination may vary from Rs 1000 to Rs 1 Lakh). In private placement, it is Rs 100,000 or above.
  2. Format: DMAT form or physical (in Printed form). Most are in DMAT forms or popularly known as Electronic format
  3. Taxation Status: Taxable or Tax Exempt
  4. Maturity: 5 years (to 7 years)
  5. Coupon: Also known as CPN which is interest payable in % terms during entire life of bond. There are three types of yields.
    1. Yield at the time of issue based on the Par value. This is same as the CPN value. If the CPN is 5%, then original yield is 5% unless there is redemption premium on maturity. If the CB is redeemable on maturity at say, 5% premium for 5 years maturity, then the effective yield is 6%.
    2. The market considers the Yield Till Maturity as effective guidance. Supposing the market price is 110, then the Yield Till Maturity is 25% (5 x 5%) + 5% (Redemption Premium) – 10% being premium paid to the market = 20% in 5 years, or 4% per year. The rise in bond price is ignored while working out YTM because on maturity, the company is obliged to pay only Redemption value regardless of the conversion price.
    3. Current Yield which is worked out = CPN/Current Bond Price. This is used by the short term investors.
  6. Interest Payment: Half Yearly or annually (mostly in Euro bonds). Domestically, the interest is based on 365 days but in Euro bonds (FCCB), the interest is worked out on 360 days basis. It is a dash higher compared to domestic bonds
  7. Conversion Price: The price at which the bonds would be converted into equity shares. For example, Rs 5000 face value (known as nominal value) worth of bonds would be eligible for conversion into equity shares @ Rs 130 per share (Current Market Price Rs 100). That is, it is issued at 30% premium.
  8. Conversion Terms: Optional or Mandatory.
  9. Optional: Most of the bonds are convertible into equity shares at the option of the holder (buyer). The holder would be encouraged to convert into equity shares if the share price is over Rs 130. Supposing the shares are trading at Rs 180 at the time of maturity, he would be at profit of Rs 50 per share if he converts. If he does not, he would get Rs 100 face value, same amount he invested before.

    In such cases, the Interest Coupon is less or it is less costly to the issuer company. During the life of the bond, the equivalents of shares are treated as “future equity issues” which results into dilution of equity. EPS of such companies are shown as basic or diluted (additional shares issuable after conversion).

    The issuer company also does not treat the bonds strictly as debt because the chances are the bonds would be converted into equity shares if the share prices remain above conversion price at any time. There is always a clause forcing holders to convert into equity if the share price remains 20% or 30% above the conversion price for certain period, say 30 days.

    Mandatory: These bonds are mandatorily converted into shares regardless of the market price of the shares at the time of maturity. These are definitely future equity because no option is given to the holder. Reliance Industries Ltd. (RIL) used to follow this route whereas other companies were following option under (1). This is why RIL scored victory over other corporate borrowers in managing its overall debt.

  10. REDEMPTION: The bonds mature on certain fixed date at the end of set period, say 5 years in above case. Such redemption could be “At Par”, that is same price at which they were issued, or at some nominal premium of 5% at the maximum. It all depends on interest coupon and conversion price. Higher the coupon or lower the conversion price, there may not be redemption premium.
  11. Some companies issue 0% Convertible Bonds (IFCI issued such bonds to nationalized banks in the past) which are issued at deep discount and pay heavy redemption premium ranging from 30% to 35% to compensate the holders of interest if the share prices do not perform well and remain below the conversion price.
  12. These bonds track the equity shares in tandem and interest rates for similar maturity in the market, especially Treasury Bonds. Each 1 percent is known as 100 basis points. If the bonds are issued at say, 5% coupon, and Treasury Yield for similar maturity is 4%, then the bonds are considered issued at 100 basis points above equivalent 5 years Treasury.

Why invest in CB/FCCB and not in Equity shares instead?

  • A good question. Whatever said and done, the CB or Convertible Bonds are “Debt Instrument” until they are converted physically into equity. The issuing company is under obligation to retire this debt at maturity if they are optionally convertible as usually the case.
  • If the company goes into liquidation, the equity turns zero, but the CB being a debt has priority over other debts, preference and equity shares, including trade creditors.
  • Some good CB issues have redemption corpus (similar to sinking fund where the company deposits regular amount to fund its future liability). It is rare nowadays.
  • In a country like USA, where the companies easily file Chapter 11 or bankruptcy, the equity holders are biggest losers, whereas the bond investors benefit most. For instance, when United Airlines filed for bankruptcy, all investors, majority of them being employees, suffered 100% loss. The bond investors got the company in debt swap for a song, and the stock which at one time sank below $1, rose smartly when it came out of bankruptcy, giving fabulous return to the chagrin of the old equity investors, most of them employees. US capitalists and private equity firms never like employee owned companies. They play dirty games to destroy them with the cooperation of lawmakers and the courts. Another major failure, Lehman Brothers, was allowed to fail only because it was majority owned by the employees.
  • In India, the nationalized banks lost over Rs 1500 crores notionally in their “Zero Coupon Convertible Bonds” issued by IFCI. They did not earn the interest for 7 years, nor did they get the shares at cheaper price. They were finally obliged to swap their debt into equity at conversion price in excess of Rs 100 whereas the current share price hovers around Rs 72. At one time after conversion, it sank as low as Rs 18, causing investment loss on paper up to 80%. 

Difference between CB and FCCB

Rupee Payment Instructions for Convertible BondsNot much difference except that the investors in FCCB are foreign investors such as FII, Pension Funds, Mutual Funds and NRI (Non Resident Indians). The exchange rate is another factor that adds to volatility and a major factor for investment. FCCB are generally issued in US dollar, and therefore, $/Rupee exchange rate plays important part. They also behave more aggressively than their Rupee counterparts, because the Foreign Investors are more agile and susceptible to market risks in terms of currency, overseas equity markets and individual health of the issuer. They are also more guided by “rating” outlook of the issuer and the country.

If Rupee gets stronger, and equity prices also rise, FCCB holders have double engine for growth – one for absolute rise in rupee value as traded on BSE/NSE, and another exchange gain.

Some issuer companies benefit due to poor market internationally even if the company by itself was doing magnificently. For instance, Hotel Leela saw FCCB prices below 50% of issue price due to crash in overseas market. It wisely bought back the FCCB issues part by part making over 50% profit.

Following are the general rules of investment into Convertible Bond and Foreign Currency Convertible Market (FCCB) which should be observed by domestic and international investors:

Investment in CB/FCCB – General Principles:
Ideal conditions exist when the following variables are in your favor:
  1. Interest rates in domestic market have peaked, are consolidating and are showing signs of going down. Inflation is now under control.
  2. The stock and bond markets are showing signs of revival.
  3. Short term interest rates such as overnight call money rates are going down or stable with downward bias.
  4. Look out for the CB available in the local market which has at least 3 to 4 years of maturity left. Also consider investing into CB IPO of established companies with at least 5 years of maturity.
  5. If you are an overseas investor, then FCCB will be the choice.
    1. In addition to above 4 factors, look at the potential of local currency, in the present example Indian Rupees vs. US dollar.
    2. If the currency of issue of FCCB is US Dollar, explore Rupee potential. If the Rupee is at lowest point with upward bias, this is the ideal situation. In this case, there could be double engine growth – one from appreciation of stock prices + exchange gains.
    3. These bonds are best bought during market crisis or crisis engulfing the nations on negative credit watch, such as Ireland, Greece, Portugal and Spain in current environment. When the government credit goes down, the corporate borrowers also suffer, even if they are better off financially.
  6. If the CB is rated or about to be rated, watch for that report.
  7. This is not a must condition for individuals because rating agencies always lag behind reality. The FII and Fund investors give high regard to rating of the bond by S&P, Moody and Fitch in Europe. Moody casts paramount influence on rating.

    Most mutual and Pension funds have limitation set by their charter to invest only in Investment grade bonds. For instance, Pension Funds in USA are not authorized to invest into any security which is less than AAA or at least AA rating. They were not buyers of India debt because Indian rating was then below investment grade (junk grade) and even now, BB minus rated, almost 5 notches lower than the desirable grade for investment.

Watch the following events:

  1. Monitor the quarterly numbers closely and see their effects on stock prices. If the stock goes higher, the CB or FCCB will also go higher. Often, FCCB moves faster than domestic CB. If the premium develops too much, better be a seller. Normally, if the premium goes above 30%, it becomes a good sell. It may be noted that premium goes down when the maturity comes nearer and nearer. In other words, the time premium will be at the highest level in first two years.
  2. Similarly, the FCCB trades at considerable discount in the event of bad news for the stock, country or just international market for equity severely correcting. (Buy opportunity)
  3. If the discount exceeds 20% to local stock price, one may do arbitrage. It is meant for seasoned investors only. There is a time lag between conversions of CB into domestic equities. (Arbitrage opportunities)
  4. If the Company performs better and better on financial front, as evident from Quarterly numbers, stay with FCCB or buy even local shares. Rely more on “sequential growth” rather than YOY number (Year on Year). The sequential growth compares the performance of last quarter to previous quarter, not previous year. You are therefore with the latest trend in the company by following sequential growth.
Anil Selarka 

Hong Kong, 1st January, 2011

 

Copyrights

© Anil Selarka, 2011

Quiz …on how much you learnt from above article: (Enclosed with full version)

QUIZ

Let me now test the practical knowledge you have gained from above article. Where would you invest $ 1 Million today? A short Quiz is enclosed for your exercise.(with full version). Finish it within 30 minutes and send your comments to this article. Make it as pointed as possible.

ANSWER KEY (with full version)

Check your answers with the enclosed Answer Sheet after 30 minutes from the Test began.

If the score is > 40; Excellent; >30<40 = Very Good ; >25<30 = Good

and if it is <25 = Poor. You have or do not have enough knowledge to invest into Convertible Bonds. Read the article again if your score is poor. You are your own teacher.

READ ONLY AFTER having attended the Quiz in previous section (enclosed with the full version)

Simple Quiz on Convertible Bonds – Test Result

This is the Answer Sheet on self testing QUIZ on Convertible bonds. The answers are posted under each question with full explanation. Enjoy your result and improve your Investment skill.

 

Anil Selarka, Author – Camp: San Diego, USA

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