Nov. 3 (Bloomberg) -- Lloyds Banking Group Plc will raise at least 7.5 billion pounds ($12.3 billion) of new capital through a bond exchange, part of the 21 billion pounds it’s seeking to exit the U.K.’s asset insurance program.

Britain’s biggest mortgage lender is offering to swap 16.5 billion pounds of bonds and preference shares for equity and new dated notes with mandatory interest payments, it said in a statement today. The new notes, known as contingent core Tier 1 securities, or CoCos, will automatically become equity if the bank’s core capital falls to less than 5 percent, Lloyds said.

Lloyds will stop making discretionary interest payments on the existing notes and won’t exercise options to redeem the debt early for two years starting Jan. 31, the bank said, citing this as a condition laid down by the European Commission. Lloyds will decide whether to call the old bonds on a purely economic basis after the two years are up, it said.

“There’s a Godfather-like element to Lloyds’ offer,” said Gary Jenkins, head of credit strategy at Evolution Securities Ltd. in London. “It’s along the lines of ‘we’re gonna make you an offer you can’t refuse.’”

London-based Lloyds is seeking to bolster its capital so it doesn’t have to take part in the government’s Asset Protection Scheme, which would have increased the U.K.’s stake in the bank to about 62 percent from 43 percent, and cost the lender 15.6 billion pounds in fees. The bank will instead pay the government 2.5 billion pounds for having what the Treasury called the “implicit protection” of the plan for the past eight months.

Popular in U.S.

Contingent convertible bonds differ from traditional equity-linked notes, which can be handed over for stock when a share rises to a pre-agreed “strike price.” CoCos became popular in the U.S. in 2006 as issuers took advantage of accounting rules to sell securities that could only be swapped for stock after the shares passed a threshold above the conversion price and stayed there for a set length of time.

To reach the trigger for the CoCo notes to convert after a 13.5 billion-pound rights issue, loan losses in 2009 and 2010 would have to be about 50 billion pounds, according to Jenkins.

The CoCo notes were rated at BB by Fitch Ratings today, two steps below investment grade, while Moody’s Investors Service rates the securities at an equivalent Ba2.

Two Offers

Lloyds plans to exchange its existing bonds and preference shares in two offers, for investors in the U.S. and the rest of the world, for as much as 1.5 billion pounds of equity and at least 6 billion pounds of CoCo notes, it said in the statement.

The new CoCo securities will be counted as core capital, the most effective cushion against losses, because they convert into equity. The new notes will pay coupons of between 1.5 percent and 2.5 percent more than those on the existing debt.

The exchange offer is part of a wider fundraising which includes a 13.5 billion-pound rights offering, Lloyds said in the statement. The new money will boost the lender’s core Tier 1 capital by 230 basis points to 8.6 percent, it said.

The cost of protecting Lloyds’ existing subordinated debt in the credit-default swaps market rose, with contracts tied to the bank’s notes climbing 2 basis points to 193.5, according to CMA DataVision prices.

Credit-default swaps pay the buyer face value in exchange for the underlying securities or the cash equivalent should a company fail to adhere to its debt agreements. A basis point on a contract protecting 10 million euros ($14.8 million) of debt from default for five years is equivalent to 1,000 euros a year.

Lloyds’ stock rose 3.3 percent to 87.77 pence as of 3:56 p.m. in London trading.

The price at which Lloyds’ new contingent capital bonds will convert into equity will be the greater of the volume- weighted average price in the five trading days from Nov. 11 to Nov. 17, or a calculation based on 90 percent of the stock’s closing price on Nov. 17 multiplied by a factor.

To contact the reporter on this story: John Glover in London at johnglover@bloomberg.net

Last Updated: November 3, 2009 10:57 EST