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Please Note: This is a general commentary based on the analysis and opinions of the fund management team of the Kotak Group and is not intended as a recommendation or for the purpose of soliciting any action in relation to any investments, or to be otherwise relied upon for any purpose.
Investments in India are subject to the normal risks associated with emerging markets, including but not limited to risk of losing some or all of the capital invested, high volatility, variable liquidity, geopolitical risks (including political instability), exchange rate fluctuations and restrictions on foreign investors. Investments in India should, therefore, be considered only as part of a well diversified portfolio.
As stock markets around the world continue to struggle and the current scenario of softening interest rates presents as a good alternative, investors are sensing an opportunity in debt instruments issued by companies, particularly those in emerging markets such as India.
FCCBs now constitute a significant proportion of foreign equity investments in India, with market value of USD $12.7 bn (Source – Kotak Institutional Equities report). Interest in trading convertible bonds, including those issued in foreign currencies has surged since the beginning of 2009 as investors return to the market. Kotak Mahindra - India’s leading financial services organisation – put this down to the large discounts and relatively low risk of investing in these ‘quasi bonds’. Typically, companies issue FCCBs in order to raise capital at a relatively lower cost for the medium term.
Before a slump in valuations in 2008, Foreign Currency Convertible Bonds (FCCBs) tended to be favored by hedge funds. Due to the lower valuations, they are now more attractive to mutual funds entering the market, especially bond and equity funds looking to buy early to take advantage of rallying stock markets in the medium to long term. The case for investment in FCCBs has become stronger due to high yields to maturity (YTM) and limited upsides in domestic equity. There is a lower risk of default as equity-raising is made easier. Also, returns can be denominated in US dollars - limiting currency risk.
With Indian growth forecasts at around 6% in the medium to long term there is scope for bonds and FCCBs to provide capital appreciation to investors in India, and achieve high gains. Since hitting a low in Q1 2009, equity markets in India have experienced good inflows with foreign investors buying USD $1.3 billion worth of Indian shares between mid-March and mid-April.These gains are expected to continue throughout the rest of the year, led by a reduction in risk aversion for investors and a belief that the Indian economy will prove particularly resilient to the global financial crisis. Indeed, optimism about India’s economy has improved in the run-up to the general election, due to finish in May 2009.
However given the current scenario, many of the FCCBs issued by Indian companies that are due for maturity in 2009 are unlikely to get converted into equity. Indian companies are finding themselves hit by the effects of the global economic downturn, with the perceived risks associated with them increasing. Many funds and institutions are selling off Indian convertibles in order to lighten their positions and account for the impact on their other positions on global portfolios.
From an investor’s point of view, FCCBs have an advantage over regular bonds as they have an ‘equity participation through conversion’ option at the investor’s discretion – typically within 3-6 years - over and above the interest component.
The demand for these instruments is increasing but the relatively illiquid market conditions due to the lack of proper market mechanism make them difficult to source. Hence the demand from the buyer, which until now has primarily consisted of Non-resident Indian nationals, is unable to match the huge supply of bonds flooding into the market as there is no direct link between the buyers and sellers. As a result of this mismatch of demand as related to supply, most of the FCCBs are currently trading at a discount of 30% to 70% to their market price, but giving high yields.The opportunity lies with the prospective buyer, who can hold on till maturity, and the rewards potentially outweigh the risks binvolved.
Today, opportunities exist not only in FCCBs issued by Indian corporations but also in government-owned Public Sector Units, which have experienced a lesser impact of the global slowdown. They have a lower default risk due to their long-standing credit history and consistent track record.
All these factors make trading of FCCBs in India attractive.
Kotak Mahindra has a full-fledged trading team based in Dubai which offers an enhanced trading capability in these debt instruments to its clients. With its vast experience on the ground and in-depth understanding of the concentration in the Indian markets, Kotak helps investors take informed decisions without making specific recommendations. Investors can benefit from Kotak’s strong long-term relationships with a wide range of market counterparties varying from large global private banks to smaller regional private banks in strategically important areas like Geneva, etc.
Kotak facilitates investment in a wide selection of bonds including quasi-government bonds, bonds issued by Indian companies, bonds from other countries like China, Indonesia, Japan, Korea, Singapore and the Middle East, allowing investors to diversify their investment risks and gain potentially stable returns under the ever-changing economic conditions. It has recognised that Indian corporates are essentially providing an opportunity to foreign institutional investors to be exposed to potentially higher yields compared to other markets across the globe. Of course, the normal risks applicable to investments such as risk of loss of capital and exchange rate risks all apply. In addition, emerging markets all have their unique geopolitical risks.