Fully Convertible Debenture (FCD)

What Is a Fully Convertible Debenture?

A fully convertible debenture (FCD) is a type of debt security in which the entire
value is convertible into equity shares at the issuer's notice. The ratio of
conversion is decided by the issuer when the debenture is issued. Upon
conversion, the investors enjoy the same status as ordinary shareholders of the
company.

KEY TAKEAWAYS

 A fully convertible debenture (FCD) is a type of debt security in which the

entire value is convertible into equity shares at the issuer's notice.
 The main difference between FCDs and most other convertible debentures
is that the issuing company can force conversion into equity.
 Fully convertible debentures give investors a way to participate in the
growth of a company while reducing short-term risk.
 On the downside, firms are likely to force conversion when it is beneficial
to existing shareholders rather than FCD investors.
Understanding Fully Convertible Debentures (FCDs)
A debenture is a medium to long-term debt instrument used by large companies
to borrow money at a fixed rate of interest. This fixed-income security
is unsecured, meaning there is no collateral pledged to guarantee the interest
payments and principal repayments. Thus, a debenture is backed by the full faith
and credit of the issuer. If the company defaults or goes bankrupt, the debenture
holder will get the invested funds back only after all secured creditors are paid.

 
Fully convertible debenture holders could receive nothing if the issuer goes
bankrupt.

A debenture can be nonconvertible or convertible. A nonconvertible debenture

will not be converted into equity. It therefore commands a higher interest rate
than convertible debentures. A convertible debenture can be converted into
common shares of the issuing company after a predetermined time. This time is
determined by the trust indenture. The convertible holder has the advantage of
enjoying any share price appreciation of the company after conversion. As a
result, convertibles are issued with lower interest rates than nonconvertible
debentures.
At the time of issuance, the trust indenture highlights the conversion time,
conversion ratio, and the conversion price. The conversion time is the period
from the allotment date of the debentures. After that time has passed, the issuer
can exercise its option to convert the securities. The conversion ratio is the
number of shares each debenture converts into and can be expressed per bond
or per 100 bonds. The conversion price is the price at which the debenture
holders can convert their debt securities into equity shares. The price is typically
more than the current market price of the stock.

The main difference between FCDs and most other convertible debentures is
that the issuing company can force conversion into equity. With other types of
convertible securities, the owner of the debenture may have that option. Unlike
pure debt issues, such as corporate bonds, fully convertible debentures do not
pose a credit risk for the issuing company because FCDs eventually convert to
equity.

Fully vs. Partially Convertible Debentures

A convertible debenture can be partially or fully converted into equity. Partially
convertible debentures (PCDs) involve redeeming a fraction of the value of the
security for cash and converting the other part into equity. A fully convertible
debenture (FCD) involves a full conversion of the debt security into equity at the
issuer's notice. The full conversion of debentures to equity is a method used to
pay off debt in kind with equity. This payment in kind eliminates the need to repay
the principal with cash.

Benefits of Fully Convertible Debentures

Fully convertible debentures give investors a way to participate in the growth of a
company while reducing short-term risk. In the years before conversion, holders
of FCDs are entitled to receive a stream of interest payments. While usually
lower than those for nonconvertible debentures, these payments come before
any dividends to shareholders. What is more, FCD owners receive payment
regardless of the profitability of the firm. For relatively illiquid long-term
investments, that can be a substantial advantage.

Another benefit of fully convertible debentures is that they can help the issuing
firm to survive difficult financial situations. If the company issues a large number
of nonconvertible debentures that mature at a specific time, the firm could face a
credit crunch if there is a recession at that time. With fully convertible debentures,
the firm avoids having to come up with the money to repay the principal. Even
better, the firm can force conversion and eliminate interest payments. Since FCD
holders then become shareholders, they also ultimately gain if the company
recovers.
Criticism of Fully Convertible Debentures
The most obvious downside of fully convertible debentures for investors is the
ability of the issuing company to force conversion. Firms are likely to force
conversion at times that are beneficial to existing shareholders rather than FCD
investors.

Suppose that the trust indenture specifies that the issuing company has the right
to convert the FCD to equity at 50% above the current price in five years. If the
share price falls 50% because the business did poorly, then the company might
need to improve cash flow as soon as possible. FCD investors will probably be
forced to convert at a substantial loss as soon as the five years are up.

On the other hand, existing shareholders will not want to dilute their equity if
share prices are three times higher because the business did well. The company
might delay conversion as long as possible, perhaps until the need to improve
cash flow arises during a recession. At that point, share prices are likely to be
lower, limiting the gains of fully convertible debenture holders.