Lloyds Banking Group Plc (LLOY)’s $15 billion of contingent convertible bonds are underperforming subordinated debt because regulatory changes threaten to prompt repayment of the notes, triggering losses for investors.
The average yield premium investors demand to hold a sample of 29 of Lloyds CoCo securities widened 25 basis points in the past month, according to price data compiled by Bloomberg. Spreads on subordinated bonds in euros tightened 21 basis points, according to Bank of America Merrill Lynch’s Euro Subordinated Financials Index.
The Lloyds bonds fell after the Prudential Regulation Authority published a consultation document on whether equity should replace the securities in the bank’s capital structure. Should that happen, under the terms of the notes Lloyds would be allowed to redeem them at par, compared with current prices of as much as 133 pence in the pound.
“There’s definitely concern there may be a call,” said Daniel Bjork, who runs the $140 million Swisscanto Bond Invest CoCo fund and has reduced his holdings of Lloyds bonds. “At some point they’ll offer to exchange them for a price between par and where they’re trading. That means the pain will be shared.”
Lloyds issued 9.5 billion pounds ($15 billion) of the securities to bolster capital ratios after a 20 billion-pound government bailout in 2008, and there are still about 9.15 billion pounds outstanding, according to data compiled by Bloomberg. That makes Lloyds the biggest issuer of CoCo bonds globally, accounting for more than 26 percent of the total, Bloomberg data show.
The notes, a type of contingent capital, automatically become equity if the issuers’ capital ratios slip below 5 percent. To compensate for that risk they carry coupons of more than 7 percent, compared with an average of 5.5 percent on bonds in the Bank of America Merrill Lynch subordinated financials index.
The lender’s 79.5 million pounds of 14.5 percent bonds maturing in January 2022 are quoted at 133.2 pence on the pound. Its $986 million of 7.875 percent bonds due November 2020, one of the larger bonds outstanding, are quoted at 106.25 cents on the dollar to yield about 6.75 percent, Bloomberg prices show.
Lloyds reported a Tier 1 capital ratio of 14.2 percent as of June 30 under stricter definitions of what counts as capital than those governing the bonds. Conversion wouldn’t take place unless ratios fell to less than 3 percent under current definitions, said Simon Adamson, an analyst at CreditSights Inc. in London.
“The bonds have become very popular because people can’t foresee a situation where Lloyds breaches the trigger but there’s little doubt that they’d be more popular if not for the par call,” said Adamson.
Other issuers of contingent capital notes include London-based Barclays Plc (BARC), whose $3 billion of 7.625 percent securities due November 2022 are quoted at 99.8 cents on the dollar and yield 7.65 percent.
Lloyds will have to replace the debt if it decides to exercise a call, meaning it will need to turn to professional investors to buy them, said Paul Smillie, a Singapore-based banking analyst at Threadneedle Asset Management, which oversees $126.6 billion.
“Lloyds will have a major hole in its capital structure if it calls them,” he said. “It will need capital markets investors on its side to fill the gap.”
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