Foreign currency convertible bonds (FCCBs) are one type of debt instrument issued in a foreign currency other than the domestic currency of the bond issuer. These bonds are also convertible to equity at maturity or a specified date.
FCCBs provide flexible capital financing options for bond issuers in a foreign market. Multi-national companies issue these with large foreign operations. However, these bonds carry interest rate and currency conversion risks for the issuers. Thus, although these bonds offer lucrative investments, they come with some risks for investors as well.
Deeper Definition
A foreign currency convertible bond (FCCB) is a type of bond that is issued in a foreign currency by the issuer. As the name suggests, it is also a convertible type of bond that can be converted into equity at maturity.
Investors can take advantage of the conversion feature of these bonds if they wish so at maturity. They can also choose to receive coupon payments during the tenure and redeem the principal amount at maturity. The conversion clause comes as an option and not an obligation.
How Does Foreign Currency Convertible Bond Work?
Multi-national companies have operations in different countries; as a result, they may need to fund foreign projects with a foreign currency debt. A foreign currency convertible bond is one such option for these companies to raise capital in a foreign market.
Bond issuers can issue these bonds if they find the currency conversion and interest rates favorable in a foreign country. Also, there would be funds transfer issues and availability of debt in the domestic market, along with the costs.
The coupon payments and principal repayment would be made in foreign currency to the investors. Investors would receive coupon payments until the maturity date. At the maturity date, they would have the option of converting the bond into shares of the company. The conversion takes place at a predefined conversion rate. If the share prices fall below the conversion rate, bondholders would rather redeem the principal amount.
Special Considerations with Foreign Currency Convertible Bonds
A foreign currency convertible bond can be issued with a call or a put option. If it is issued with a call option, the issuer can redeem the bond before the maturity date by paying off the principal amount to the investors. Similarly, if it is issued with a put option, investors can redeem the principal amount from the bond issuers before the maturity date.
Investors have the option of converting bonds into equity after a specified period. Bond issuers attach warrants with these bonds to attract investors. If the share prices of the company appreciate, investors will utilize these warrants. However, the conversion doesn’t come as an obligation for the investors.
An advantage for bond issuing companies is a lower coupon rate with the FCCBs. As these bonds come with a conversion to equity benefit, bond issuers can afford to offer a lower coupon rate than a straight bond. Contrarily, an adverse movement in the currency conversion rate, such as weakening the domestic currency of the bond issuer, will increase the cost of debt (higher coupon payments) for the issuing company.
Benefits of Foreign Currency Convertible Bonds
FCCBs offer several advantages to the issuers and investors as they come with a conversion clause and in a foreign currency.
- Issuing companies can raise capital in a foreign country with favorable interest rates and currency conversion costs.
- Issuers can afford to offer lower coupon rates on FCCBs than on plain vanilla bonds.
- Bondholders and issuers have redemption options through a call and a put option, respectively.
- Bondholders can choose to convert the bonds into shares of the issuing company through attached warrants after a specified period.
- Investors enjoy the dual benefit of owning a debt and equity asset at the same time.
- If investors convert the bond, the issuing company can reduce the debt and improve the company’s debt-to-equity ratio.
Limitations of Foreign Currency Convertible Bonds
Foreign currency convertible bonds offer some risks and limitations to both parties as well.
- Investors receive lower coupon payments as compared to a straight bond.
- The cost of debt can increase for the issuing company due to an adverse currency exchange movement.
- Investors face credit and foreign currency exchange rate risks.
- Investors cannot decide the conversion rate of these bonds.
- The issuing company would face dilution of shares if most investors chose to convert. Contrarily, if the majority of bondholders do not convert, the company would need to repay the principal amount.
- An adverse stock market or domestic currency performance would mean the bond’s price will fall drastically.
Final Thoughts
A foreign currency convertible bond is a bond issued in a foreign currency and comes with a conversion clause. Investors hold the option to convert these bonds into equity after a specified period. These bonds offer flexible capital financing options to the issuers. Investors can convert these bonds into equity or redeem the principal amount and receive coupon payments.
