Five years after wiping out sizeable profits of Indian banks’ overseas offices, credit default derivative could be making a comeback. Only last week, Standard Chartered Bank has provided credit default protection of up to 90 per cent of the face value of the $130 million foreign currency convertible bond (FCCB) issue of auto component maker Amtek India Ltd.
Credit default derivatives is a protection or an assurance that a bank gives to a lender (or a bondholder in this case), against the eventuality of a default by the company. Hence, the bondholder carries minimal risk on the bonds and is assured of the downside by the bank.
Till 2007, Indian banks, through their overseas offices, underwrote huge credit derivative businesses for the FCCBs which were issued by Indian companies. With the sub-prime crisis resulting in foreign lenders turning risk-averse and widening the spreads, these banks had to book huge losses on their portfolio. After that, Indian banks have not indulged in such fancy instruments again. But with Standard Chartered providing protection to Amtek’s bondholders, there is a possibility that the trend might reverse.
Repeated attempts to reach Arvind Dham of Amtek India did not yield results, though. The spokesperson of Standard Chartered also refused to comment on the development, citing client confidentiality.
“Giving up to 90 per cent of credit protection against the bond is very high and is akin to stripping the bond off its equity element as the downside risk of the share price not performing is protected,” a hedge fund manager said.
Indian firms had extensively raised FCCBs, a quasi-debt instrument, in the bull run of 2005-2007 to fund expansion. During that period, Indian banks provided credit default protection up to 30-40 per cent of the issue size. “The exposure was limited at that point of time but with the sub-prime crisis widening the spreads, the banks charged the lenders or bondholders and banks world over booked huge credit derivative losses,” a senior debt capital market official with a foreign bank said.
In 2007-08, banks like State Bank of India, Bank of India, Bank of Baroda and ICICI Bank had burnt their fingers with these credit derivatives. Banks built a sizeable book out of such derivatives during FY07, betting on a high risk-high rewards business.
FCCBs are bonds with an equity element although they remain debt instruments as long as investors hold on to them. Investors can convert their holdings into equity when the share price touches the conversion price promised by the issuer. If this does not happen, the issuer needs to treat the bonds as debt and redeem those. Usually, the default risk is borne by the company that issues such bonds where it has to pay the bondholders on maturity.
During the bull run, Indian promoters did not treat the bonds as debt and did not provide for redemption, thinking that the stock markets will outperform and the rise in stock prices will result in conversions without straining resources.
But with the stock markets nosediving from January 2008, the stock prices of companies have considerably suffered – resulting into fewer conversions into equity shares as it makes no sense for bondholders to convert at a higher price than the market price. Indian companies are now grappling to pay off the bondholders, with an estimated $6 billion of FCCB redemptions coming up in the next 12 months.
To ward off the fear of redemption and also to provide bondholders with some level of comfort, Amtek India has promised to redeem the bond at 100 per cent of the principal amount, along with the accrued interest on maturity, in 2017.
“The equity risk has been stripped off in this case since the bank is giving protection up to 90 per cent of the bond value,” the hedge fund manager said.
Public-listed firm Amtek India is a subsidiary of PE-backed Amtek Auto, the flagship auto component company of the Amtek Group. Amtek Auto is backed by marquee names like Warburg Pincus and ChrysCapital. Both the PE investors had earlier cashed out by selling their stake in Amtek India (more on that here), which currently commands a market cap of Rs 2,918 crore or $570 million.
Since FCCBs are treated as unsecured debt with a bullet payment (one-time payment) at the end of the tenure, the risk that the bondholders carry is huge. “As their past experience with Indian companies was not satisfactory, many investors are wary of investing in Indian firms and unless given some kind of protection, they will not invest,” the aforementioned banker with the foreign bank added. According to him, payment defaults by companies, such as Wockhardt Ltd and Zenith Infotech, have made a huge dent in the confidence that the bondholders previously had in Indian companies.
Most of the Indian companies which are staring at huge redemptions in the next one year, are trying to push the deadlines further or restructure bonds to avoid defaults. Some are trying to raise fresh FCCBs to retire old debts but are unable to find investors, experts say.
Whether credit derivatives are back in the market to help such companies raise money is still a question. “It is too early to say this is a trend reversal. Not every company will enjoy the confidence of the lender and not every company will be a compelling investment opportunity for investors. We have to see it on a case-to-case basis,” argues a banker who had helped companies raise money with such credit protection.