Jury out on wider appeal for Lloyds' new hybrids

 

Lloyds looks set to get investor support for a hybrid bond exchange into 7.5 billion pounds of new enhanced capital notes (ECN) but it is not clear how much wider appeal these new securities will command.

That wider appeal could be enhanced not just by the outlook of current investors in Lloyds' Tier 1 and upper Tier 2 bonds - and the performance of the transaction - but whether there will be continued regulatory approval for existing hybrids.

The bonds convert into equity under certain circumstances, hence their alternative name of contingent convertibles/capital.

"I guess there are enough carrots and sticks to make sure this should be a successful transaction" said Oliver Judd, financials analyst at Aviva.

He said the Lloyds' exchange offered investors more in terms of coupon and certainty in terms of maturity.

"It's a new instrument and it remains to be seen if this is indeed the future" Judd said.

Last week the UK bank, part-owned by the government, unveiled a 21 billion pound capital raising to free itself from a state insurance scheme for bad debts.

This included the exchange of certain hybrid bonds into these contingent convertible securities, which automatically convert into ordinary shares if Lloyds' core Tier 1 capital ratio falls to less than 5 percent. 

The new securities would be classed initially as Tier 2 hybrid debt and then become core Tier 1 capital if they converted to equity.

At the same time, EC conditions on state aid has stipulated that Lloyd's existing hybrids will not pay coupons or be redeemed for two years from January 31, 2010, making the new ECNs a more attractive investment proposition.

The deadline for investors to accept is November 20.

The new securities offer an implied yield that point to the likely success of the issue.

For example, Lloyds hybrid bond 13 percent perpetual were yielding 12-12.5 percent, versus an implied yield of 11-12 percent for the ECNs.

"It is my belief that there will be a viable new issue market for these instruments going forward" said Robert Ellison, executive director at UBS. "But the jury is still out" said Ellison, who was speaking at Thomson IFR's Financial Institutions Group Funding conference in London.

"On a conceptual basis I wouldn't have a huge issue buying these" said Colin Purdie, fixed income investment manager at Aegon Asset Management UK. But Purdie said that it would depend very much on the nature of the institution and the terms, especially the trigger ratio and how remote he viewed the risk of conversion actually taking place.

The case of this conceptual question turning into a reality is growing fast, with regulators and index providers seemingly behind the new product.

EQUITY TIMEBOMB 

On Tuesday, Bank of America Merrill Lynch changed its mind and opted to include the Lloyds ECNs in its bond indexes, but some British investors have objected.

The Association of British Insurers is opposed to these bonds joining the Merrill indexes because this will require some bond investors to buy them and then to become forced sellers if they convert to equity.

Their conversion to equity when a bank's capital is running low makes them less attractive to investors.

"It converts into equity just when you don't want to own the equity" Alan Brown, group chief investment officer at Schroders, said at a recent media briefing.

Some bankers said the Lloyds deal could end up being a one-off because of the bank's distressed situation.

"It has the veneer of a Lower Tier 2 (hybrid) instrument, but is actually equity capital in a stressed environment" said one senior banker.

Standard & Poor's, the credit rating agency, has expressed doubts about how big a role contingent capital can play for banks.

"We expect there will be investor interest in contingent capital securities, but we do not yet know whether they will remain a niche product or become a more mainstream part of the bank capital funding market" S&P said in a report.

"Contingent capital securities may not be sufficiently attractive to investors at a price that is also attractive to the issuing banks." 

Analysts point to recent issuance of traditional bank hybrids to show investors remain happy to buy these bonds.

"Continental EU banks have successfully sold old-school Tier 1" said Judd, pointing to Societe Generale and Credit Agricole as examples. "There is investor appetite, why would a borrower pay up for this equity if they didn't have to?"