Analysis & Comment > bond-of-the-week
Bond of the Week: 3 November 2009
Lloyds preference shares: 3 November 2009
As readers of this column will no doubt be aware, Lloyds TSB is yet again re-financing. Equity holders will be diluted, with a £13.5 billion rights issue to swallow. Senior bondholders will be broadly unaffected, but holders of Lloyds and HBOS subordinated paper, in particular preference shares, will be bearing a considerable part of the pain. The bank intends to make an exchange offer for over £7.5 billion of this class of debt, swapping the bank’s existing liabilities for a new class of instrument known as a "COCO", or Contingent Convertible.
Popular preference shares affected include:
Tuesday’s closing price and the move on the day shown in brackets
52 securities in total qualify for exchange and the full list can be viewed on this morning’s RNS, available on the LSE’s website here.
So why is this happening? The rationale is that the bank wishes to avoid the government taking a larger stake, and is thus forced to raise more equity in the market and also boost its capital ratios. One factor is the European Union’s insistence that holders of "hybrid capital" securities (i.e. certain classes of subordinated debt) should not be rewarded whilst the bank is a beneficiary of state aid. Thus, no coupons will be paid. To a certain extent, the bank has used this ruling as a lever - effectively saying to the preference share holders "either switch into the new securities or lose your income".
With regard to the new securities, a variety of the "COCO bonds" or Enhanced Capital Notes (ECNs) will be issued as replacements for the existing securities. These new securities will be lower tier two qualifying liabilities, effectively the same class of subordination as the preference shares, but with an added feature - should the bank’s tier one capital fall below 5%, the ECN will convert into equity. That’s not so good! Unlike conventional convertibles that have upside exposure and downside protection, these securities will only convert to equity if things go wrong. The new securities have been rated BB, below investment grade by Fitch.
However, on the positive side, the ECN will not have their coupon’s blocked by the EUR ruling and will have a final maturity date.
As an example, I hold a small amount of the Lloyds 9.75% preference share in my ISA. I will be offered the option to exchange these for the "series 5" ECN. The series 5 ECN has a coupon of 11.25%, a pick up of 1.5% from the current security. The new ECN will also have a fixed redemption date in November 2024, which is a mixed blessing, depending on one’s views on long-term interest rates.
There are also share and cash options, with £100 million set aside for the purchase of holdings from "retail investors" ( ie. private investors). The full exchange offer can be downloaded from the Lloyds website here.
My view: to a certain extent, this development has already been discounted into the market. Indeed, the price of Lloyds ordinary shares was up a couple of pence on Tuesday, closing at 87p. Seemingly, the prices in Lloyds and HBOS preference shares have not, as yet, been greatly impacted. It may take some time for the dust to settle in these securities as investor digest the ramifications of the complex offer and consider their options. Judging from the market reaction, which has seen some of these securities marked higher, and some lower, the decision to sell or convert should be made on a case-by-case basis.
However, my instinctive reaction to this offer is negative. There is an element of the preference holders being bullied into the new securities. Those who choose to sit tight on their old bonds and skip a couple of coupon payments will likely find that they are stuck with an illiquid "rump" holding. Also, the new structure, with its "worse case" equity conversion adds uncertainty, and that is not a good thing, particularly in fixed income investing.
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