December 01, 2009
Lloyds's CoCo Bond Exchange Offer is Massively Oversubscribed
Posted by Rob Beard

Yesterday I introduced the CoCo Bond concept generally; today I’ll dive in to the new use and form that has elicited some very strong market reactions.  I’ll begin by discussing the Lloyds issue (the only new CoCo in progress thus far).  Tomorrow I’ll explain why many regulators believe CoCos modeled after the Lloyds issue can transform institutions deemed too big to fail.

On November 3, Lloyds Banking Group, plc offered to exchange up to £7.5 billion of its outstanding subordinate bonds for a new form of contingent convertible debt—CoCo Bonds (sadly, Lloyds chose to christen them with a much less interesting title: Enhanced Capital Notes, or ECNs).  Lloyds’s CoCos work differently from the CoCos issued earlier this decade.  The old CoCos tied conversion triggers to asset price, and generally provided bondholders the opportunity to participate in share price appreciations (because conversion was based on a conversion premium multiplied by a conversion trigger in excess of 100%) while receiving a fixed coupon.  Lloyds’s conversion trigger is not based on asset price, however, but on a determination of Lloyds’s safety and soundness, as measured by its core Tier 1 capital ratio. 

Though it may initially sound complicated, the Lloyds CoCo operates in a fairly straightforward way: bondholders receive a coupon for a certain period of time, just like they would if they held a traditional bond.  If Lloyds’s core Tier 1 capital ratio drops below 5%, however, the Lloyds CoCo would automatically convert to a predetermined number of ordinary equity shares, and the bondholder would become a shareholder, losing all attributes of the bond. Conversion is mandatory upon the triggering event. 

Lloyds offered to exchange CoCos for its outstanding subordinated bonds as one element of a two-pronged recapitalization program designed to allow Lloyds to escape the UK’s Government Asset Protection Scheme (GAPS) (the other element is a rights issue).  Lloyds believes that exchanging ECNs for its subordinated debt will provide the bank capital without diluting shareholders at the time of issue, and in the event Lloyds falls on hard times, the conversion will trigger and Lloyds will benefit from a large Tier 1 capital boost. 

Though the exchange provides Lloyds this contingent cushion, it comes at a cost.  ECNs pay a coupon anywhere from 150 to 250 basis points higher than the subordinated debt they replace.  In simple terms, Lloyds is paying a premium for the exchange, and £500 million in fees associated with the offering.  The question, then, is why issue CoCo Bonds now?

Lloyds prefers to pay the coupon premium over its other option: participation in GAPS.  For Lloyds, GAPS participation would have meant issuing preferred shares to Her Majesty’s (HM) Treasury at a cost to HM Treasury of £15.6 billion.  These shares would have converted into 13.6 billion ordinary shares (a) at HM Treasury’s option or (b) automatically if Lloyds’s shares appreciated to a certain level.  This would have been a substantial dilution to ordinary shareholders.  In addition, GAPS participation placed Lloyds in a less favorable position before the European Commission, which is in the process of restructuring large financial institutions that heavily rely on state aid.  Finally, the European Commission signaled its intent to prevent Lloyds from paying any coupon on its subordinated debt for two years—part of the EC’s plan to make bondholders feel some pain.

So we know why Lloyds is issuing CoCos, but this raises more questions.  Why would a U.S. bank issue CoCos? (spoiler alert: Chris Dodd wants to force them to)  And why would the EC prevent Lloyds from paying coupons on its subordinated debt, but approve an exchange that ultimately results in Lloyds paying a 1.5% to 2.5% higher coupon?  And, finally, why would an investor purchase CoCos outside an exchange situation?  I hope to shed some light on these issues (and more) as I progress throughout my guest blogging tenure.

In short, the Lloyds offer has thus far been a surprising success: investors sought to exchange £12.51 billion worth of bonds (on a £7.5 million offer), encouraging Lloyds to expand the offer (it has so far accepted £8.5 billion). Given its unique nature, Lloyds's issue may seem like a one hit wonder.  Regulators appear to see things differently.  Tomorrow I’ll turn to the part regulators are playing thus far in the CoCo story, and what they expect CoCos can do for them.

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