The growth story panned out, but it might have finished a little earlier than most investors thought. The Bombay Sensex index rose in a virtually straight line from about 4,300 points in September 2003 to a record high of 20,873 in early January this year, but then it all came crashing down and the index is now just below 13,500.
Many of the CBs have already been converted into equity, but there are a number of companies with bonds that have either been only partially converted or are still outstanding in full. And while some of these still have time to await a potential rebound in the share price, the five-year bonds issued in 2004 will reach maturity next year.
For some of these companies, which are trading deeply out of the money, the amount they will have to pay back to the bondholders is not insignificant û and it is the small- and mid-cap companies that could be hurt the most.
The first CB to reach maturity will be Bharati Shipyard, on December 1 this year. The company has $14 million worth of bonds still outstanding out of an original deal size of $20 million, which equals 11% of its market cap. According to consensus estimates compiled by Barclays Capital, the market currently believes there is a 0.07% probability of conversion. This is no surprise, considering the equity price is currently at Rs217.45, while the conversion price is at Rs421.90.
Out of the batch of Indian convertible bonds that will come to maturity next year, pharmaceuticals company Wockhardt is the most exposed, with $100 million still outstanding on a bond maturing in October 2009. This accounts for 27% of the company's market cap, and at present the market believes there is only a 0.2% probability of conversion. Friday's closing price of Rs165.55 is way below the conversion price of Rs486. The amount still outstanding that matures next year is $647 million, spread across seven companies.
The potential problem gets bigger when looking forward to 2010 with $1.47 billion worth of maturing CBs across 21 companies, according to Barclays data. While they obviously have more time before reaching maturity, there are companies with large CBs relative to their market cap that are already looking unlikely to see the debt convert into equity. The $34.5 million that remains on a CB issued by Aftek Infosys accounts for 57% of the company's market cap and the market believes there is currently only a 4.39% probability of conversion.
ôIf they have to pay it back through their cash flows it could be very, very difficult,ö says a convertible bond specialist.
However, others say one shouldnÆt exaggerate the situation.
"While it is fair to say that the current state of the markets and the fact that a lot of CBs are trading more like debt than equity has taken issuers by surprise, we believe that there is no cause for panic" says Aloke Gupte, a vice-president at J.P. Morgan who handles equity-linked and corporate derivatives for Asia.
There is need for careful planning and flexibility, but not panic, he says. ôWhile the share price growth required for the convertible bonds due in 2011 and 2012 might look challenging today, we do believe that there is enough time for markets to stabilise and that issuers will have access to multiple refinancing opportunities."
Convertible bonds have been popular across Asia, and some Singaporean CB issuers could find themselves in a similar situation when their bonds become puttable in 2009. However, there are a number of factors that makes this primarily an Indian story.
ôWhat stands out in India is that the convertible bond market has been an instrument of choice for fast growing companies, many of which have suffered from a very steep drop in the share price and have few refinancing alternatives," says Nicolas Vong, head of equity derivatives and financing, Asia-Pacific, for Barclays Capital. ôAnother thing specific to India was the enthusiasm, and that people were willing to pay a high premium.ö
Indeed, according to the term sheets at the time, coupons of 0.5% or less and conversion premiums above 30% were not uncommon.
The other factor is India's tough regulatory environment, which limits how much a convertible bond can be customised to the situation. This was not much of a problem during the bull market when many of these bonds were issued, but when credit tightens up, it is more difficult to get investors on board if there are limits on how attractive the deal can be. For example, the Reserve Bank of India, which regulates debt in India, does not allow CBs to be priced at a wider spread than Libor plus 350bp.
The regulators also limit how low the conversion price can be reset during the maturity of the bond. Using a reset to lower the conversion price within the limits may encourage investors to convert, but the use of such a feature will depend on the ability and willingness of the sponsors to increase the equity dilution.
ôOffering foreign currency convertible bond investors an option to convert at lower prices, however, need not necessarily lead to conversion as has been noticed in certain cases where the conversion price had to be reduced more than once,ö says Rakesh Velecha, senior director at Fitch Ratings in India.
For a company with a convertible bond on its books that is reaching maturity in the next year, the focus should be to start planning the refinancing as soon as possible, say CB bankers. And it might not be wise to wait and see whether the credit markets pick up. ôThe terms may not be great, but if it is good for your business, it makes sense to do it now,ö the CB specialist says.
With this first generation of convertible bonds reaching maturity, maybe there is a lesson for companies that are thinking of raising capital through CBs in the future.
ôEven in a market which has a fantastic equity story, you should not be thinking of the convertible bond as something that will definitely convert. You should plan for a situation where markets don't turn out well û remembering that the markets might not be your ally, even if the business is doing well,ö the CB specialist says. And herein lies the irony û many of the businesses that have issued convertible bonds that are trading out of the money have been very successful at an operational level.
Fitch's Valecha thinks that corporates should keep in mind that convertible bonds are fundamentally debt: "You can't count on the equity markets being benign across the tenure of the foreign currency convertible bond; the risks of non-conversion exposes corporates to significant refinancing risk which may get accentuated in tight credit markets."