The Hindu Business Line : Understanding exchangeable bonds

The Finance Minister, Mr P. Chidambaram, introduced the term Exchangeable Bonds (EBs) to the Indian financial market’s vocabulary in his Budget Speech of 2007. However, EBs did not find any specific mention in his latest Budget Speech.

While the much-awaited guidelines with respect to Foreign Currency Exchangeable Bonds (FCEBs) were issued by the Finance Ministry recently, the country still awaits detailed guidelines on domestic EBs which facilitate domestic fund raising activity.

It is relevant to note that internationally EBs are not a new concept at all. They are recognised as well-acclaimed instruments of raising debt in the world markets.

What are exchangeable bonds?

An EB gives the holder the option to exchange the bond for the stock of a company other than the issuer (usually a subsidiary) at some future date and under prescribed conditions. So one can say that it is a quasi-debt instrument that carries a burden of periodic interest payment and is callable at preset prices, that is, bond holders have a call option on the bonds before maturity.

The issuer could be a holding company, an operating company or a special purpose vehicle (SPV) depending on the market and more specifically upon the business advantages for the issuer.

If there is a business case for selecting an SPV as the issuer company, typically a full guarantee is required to be given by the company of substance or a third party in favour of the SPV.

Most of us are aware of another category of bonds (convertible bonds) that grant the bondholder similar rights, except for a specific difference that a convertible bond converts into equities of the same company, that is, the issuer (referred to as holding company) and not for the shares of the group companies as in the case of EBs.

Thus EBs act as a very effective disposal mechanism for the holding companies of the shares held in their subsidiaries (referred to as operating companies).

What’s THERE for stakeholders?

EBs serve as an effective tool for the holding companies to monetise their shareholding in the operating companies in case of fund requirement without immediate divestment of their stakes.

The issuer company may take advantage of high expectations and business valuation of its operating subsidiaries to issue such bonds on favourable terms. This proves to be an effective tool for disposing of the shares by a holding company in its subsidiaries; thereby unwinding interlocked corporate holding.

Unlike the convertible bonds, which on conversion into equity of the holding company result in dilution of issuer’s shareholder’s equity stakes, EBs prevent the occurrence of dilution of stakes. At the same time, EBs enable the holding company to exercise its voting rights in the subsidiaries until the conversion happens.

EBs give an opportunity to the bondholders to benefit from any increase in the value of equity linked to the bonds issued. Periodic interest payments keep the bondholders interested!

EBs facilitate portfolio diversification for the bondholders who otherwise would not have considered investing in the subsidiaries of the holding company.

In developed markets, EBs themselves can be traded even when not converted into equity. Thus a market exists even while the instrument is a bond.

Some of the instances of Global EB transactions are given in the Table. The sample of examples clearly evidences the potential benefits which could accrue to the interested parties. One can clearly gauge how critical it is that the terms and conditions of EBs are well thought through both from the issuer and the bondholder’s perspective and built into the agreement upfront. Agreements can be appropriately structured to incorporate varied considerations of the parties concerned.

Listing of EBs on the stock exchanges is a common feature of global EB transactions which are quite highly appreciated, especially in the EuroMarket.

Indian vs global picture

With the ever increasing exposure of the Indian industry to the world markets and the increasing globalisation of the financial instruments, introduction of one more global financial instrument, namely “EBs”, in the Indian markets is inevitable. In light of the performance of this breed of debt-equity instrument at the global stage and the resulting benefits, EBs appear to be a win-win story for its stakeholders in this growth scenario.

The recent FCEB guidelines have a specific mention of the income-tax implications arising on issue and transfer/conversion of FCEBs in addition to the foreign exchange regulations as may be applicable. Though prima facie the guidelines envisage certain tax exemptions in India upon exchange and transfer of FCEBs on one hand, on other hand there are a number of in-built regulatory approvals to be obtained.

We hope that the Indian regulatory authorities take some cue from the successful EB transactions abroad and draft the regulations accordingly with necessary inputs from the Indian corporate houses. It is only then that EBs would be as successful a story in India as it is overseas.

With the constantly increasing need of the Indian companies to raise funds, more importantly from foreign sources, it has now become a critical that detailed and clear-cut guidelines on EBs (not just FCEBs!) are issued by the Finance Ministry and their implications under various other applicable laws, such as the Companies Act, the Income-Tax Act and SEBI laws, are brought onto the table. Until then it’s a wait and watch game for the Indian corporates and one hopes the game ends soon!

(The authors are Manger (Global Tax Advisory Services) and Principal (Transaction Advisory Services), respectively, Ernst & Young.)