The New Era for Bank Bonds: Send In The Clowns?

The following is a long piece, but we feel it has potentially dramatic implications for the bank bond market.

Last week saw the much anticipated capital raisings from Lloyds-HBOS and RBS. Lloyds has managed to raise £13.5 billion in new shares with HMT’s holdings remaining at 43%, whilst RBS has raised £25.5 billion from the Treasury, and a further £8 billion from the Treasury in the form of contingent capital notes. This sees the taxpayer’s economic interest in RBS rise to 84%. Lloyds is also raising between £7.5 billion and £9 billion from the exchange of old subordinated bonds (upper tier 2, tier 1 and preference shares) into new contingent capital notes.

Lloyds’ total capital raising sees it avoid the Government Asset Protection Scheme, wherein HMT guarantees 90% of losses incurred on a book of toxic assets, although it will have to pay £2.5 billion in break-up fee for the confidence boosting that the implicit support provided by the scheme has given to the company over the last 9 months or so. RBS, though, has not managed to avoid entrance into this scheme, but managed to reduce the amount of assets going into the protection scheme from £325 billion to £282 billion. As a sign of the toxicity of these assets, though, RBS’ first loss piece was increased by £20 billion to £60 billion.

But there is a cost to both these companies for their needing substantial government support, and for, indeed, almost bringing down the UK economy. Indeed, last week’s actions clearly indicate that RBS remains entirely reliant on the government money for its survival. The EC has ordered Lloyds to shed 4.6% of its current account market share, and 19% of its UK mortgage market share, by 2013, with a clear drive to try to reduce concentration in the banking system and to avoid banks being ‘too big to fail’. RBS once again comes off worse from this part of the restructing: RBS will be forced to sell its insurance businesses, arguably the most attractive part of the group at the moment, as well as large numbers of branches in the UK, its payment processing business and its interest in a commodity trading arm. Ultimately, we feel that it is in some way right that Lloyds is given the chance to make a clean break from the APS, given that it bailed out HBOS at the height of the UK banking sector’s woes and at the same time decimated its theretofore strong franchise. RBS, in contrast, was not so much a solution as a large part of the problem, and in some way has been and will continue to be treated as the UK banking sector’s whipping boy.

But the most relevant part of all this to us as bondholders, aside from the clear and much-needed improvements in the equity positions of the two banks, is the liability management exercise being undertaken by Lloyds to generate £7.5 billion in contingent capital from exchanging existing subordinated noteholders. On top of ordering the two banks to sell parts of the businesses, the EC has also ordered that the two banks cease payments of all discretionary coupons on subordinated debt (to not pay coupons on senior debt or lower tier 2 is, currently, an event of default) from January 2010 to January 2012. This is a very substantial development, and one that we have been expecting to be imposed on problematic banks for quite some time. It appears that large numbers of deeply subordinated bank bonds are going to become non-coupon paying for the next two years, and there will be no calls over that period either. We are a step nearer to zero coupon paying perpetuals!

So the response from Lloyds? Astonishingly, the bond exchange has been designed to take out some of the bonds that the EC would have enforced non-payment on, swapping instead into a must-pay security.  But the EC’s push to enforce non-payment of coupons was presumably justified by the need to preserve cash within the business rather than leaving it? So either you hold your old Lloyds hybrid notes and take a 2 year payment and call holiday, or you exchange into the new contingent capital, or CoCo, bonds, that must pay coupons unless converted to shares. And in our view, from the banks’, regulators’ and the taxpayers’ perspectives, the new capital notes are a very good idea. Simply put, you get a bond that must pay coupons each year, and that have a definite maturity of 10 to 20 years (like a senior bank bond or a corporate bond). But: if the bank gets into trouble, and its core capital falls below a certain level (5%), then your bond gets automatically converted to common stock. We here think that this is the future of the hybrid capital note market. In times of trouble these subordinated bonds will actually convert to equity (just when banks need it most!). We got into this banking crisis thinking the banks were ‘well capitalised’, and we soon found out that most of their capital was more bond-like than equity-like, which wasn’t much of a help at all to a severely under-capitalised banking system. These CoCo’s would correct that. Good.

But there is a plethora of problems and inconsistencies with these new bonds. Regulators have agreed to allow these CoCos to be mandatory pay securities, so cash will continue to exit the business to pay coupons, which is exactly what the EC wanted to stop. Furthermore, to entice old bondholders to exchange into the new notes, and to reflect the increased risk of a mandatory conversion to common equity, Lloyds is offering coupons on the CoCos that are 1% to 2% higher than the old subordinated bonds. So even more cash will be leaving the business than before! Moreover, the bonds have been classifed as lower tier 2 for purposes of seniority of payment and in liquidation, but regulators will consider them at the same time as contingent core tier 1 capital: isn’t that a contradiction in terms? It seems to us that regulators are being overly accomodative to get this deal done, and to help recapitalise Lloyds, and to open this new CoCo market. We do expect other banks to explore the feasibility of similar issuances once the market has got used to this one. From bond investors’ points of view, though, these look like bonds until distress, in which case you are automatically converted to common stock (unlike convertible bonds, where it is generally your right, not obligation, to convert). So they don’t naturally fit into the fixed income universe. At the point of conversion, given distress, the shares will be worth very very little. And the risk of Lloyds-HBOS’ core capital falling to or below 5% is non-negligible, in our view, especially in the next 3 years. Finally, given how high the coupons are going to be, isn’t a management team or regulator at some point going to be incentivised to manipulate their capital levels to force conversion of this expensive debt into cheap equity?

We don’t think that these bonds naturally fit into the fixed income space, although the yields do look attractive. Thus, if other, stronger banks bring similar deals, where there is a premium paid for potential equity conversion over existing tier 1 yields, and where we feel the risk of exchange to equity is sufficiently remote, we will consider them carefully. However, there are still several potentially large issues for these notes, nicely exemplified by a certain index provider’s excluding them from the index on Tuesday, then re-including them, and then yesterday re-excluding them. This shows how difficult is it to know whether they should be classified as fixed income or equity. And that would suggest that the powers that be are worried about who exactly will buy these new CoCo The Clown notes. Are these clowns happy, or are they sad? Are they bonds or are they shares?

Discuss Article

  1. Edward Painter says:

    Ben

    Whilst it may make sense from a funding point of view to force conversion wouldn’t that amount , even allowing for some manipulation, to a near collapse of the bank from a regulatory capital perspective? I can't see any management team looking to do that.

     

    Posted on: 12/11/09 | 12:00 am
  2. Anonymous says:

    Great article and a very helpful explanation of this new hybrid instrument.  Many thanks.

    Posted on: 12/11/09 | 12:00 am
  3. Tony Stubbings says:

    Very interesting.

    An associated point: is it still the law that Lloyds is forbidden to pay dividends on its ordinary shares as long as it defers payments of discretionary preference coupons ( whether between January 2010 and 2012 or thereafter) or – given that  Lloyds will be making payment of ECN coupons mandatory  – has the rule on not paying dividends on ordinary shares been altered as well?

    Posted on: 12/11/09 | 12:00 am
  4. longodds says:

    Good article
    Gillian Tett at FT also covered clown bonds, see linkhttp://www.ft.com/cms/s/0/797f2cb6-cfb5-11de-a36d-00144feabdc0.html

    Posted on: 13/11/09 | 12:00 am
  5. Ben Lord says:

    Edward,

    I agree that in the normal course of business no management team would want to send out the signal that it was near collapse by having the exchange made. But we aren't talking about a 'normal' business environment at all, in our view. Plus a 5% core tier 1 ratio is not that far from the realms of possibility: it is a much higher level, for instance, than the level of core capital the company had before all the losses were incurred from this crisis.  Furthermore, ultimately management will be at the mercy of shareholders, and if management believes that additional funds will not be forthcoming from this source, then the exchange may come to look like the only place to add equity from, regardless of any economic attraction of so doing.

    It is probably worth mentioning, too, that the conversion prices on the CoCos will be fixed dependent on the equity price this week, long before the rights issue (and resulting dilution) is priced in in February 2010. Thus, it is highly likely that the exchange of the CoCos into shares will be restorative rather than dilutive to the share price, which could have an effect on the management's and shareholders' perceptions around the exchange. Essentially, if the exchange was going to be dilutive to shareholders, management and the owners may be less inclined to see the exchange being enforced because their holdings' value will fall. Contrastingly, because the exchange will very likely be 'restorative' rather than dilutive, management and shareholders could, counter-intuitively, view the exchange somewhat more positively.

    Posted on: 16/11/09 | 12:00 am
  6. Ben Lord says:

    Tony,

    In the event that the EC gets its way and the proposed changes take place, then, yes, the dividend will also be cut from January 2010 to 2012. It is worth mentioning that nothing is totally finalised as yet, and that official approval remains pending. In the case that the changes are not enforced, Lloyds will have successfully frightened investors into the exchange with the threat of non-coupon payment. The EC has changed its mind before, but given Lloyds has used this very issue as the main motivator to exchange, we view it as being more likely than not that they are indeed forced to make the changes as discussed in the article.

    Posted on: 16/11/09 | 12:00 am
  7. Bill the bond Journo says:

    Surely the value of the CoCo bond would depend to some extent on the conversion terms from bond to equity in the event of the trouble coming. Is it on a number of shares basis or an equivalent value basis? If the former then this bond is quite risky,  because by the time you got the shares they probably wouldn't be worth much anyway (because the bank is…er….in trouble).

    Posted on: 18/11/09 | 12:00 am
  8. Thecommissariat says:

    A few inconsistencies have appeared in the comments. Lloyds Banking cannot pay any dividends on equity while hybrid debt left out of the conversion is not paying interest and plenty of this will exist, as the cut off point for conversion seems likely to miss out a number of bond and preference issues.
    The "unadjusted" conversion price of the CoCos has now been announced as >89p and the "adjusted" conversion price should be known shortly after the ex rights date.
    The "February 2010" price announcement relates to the Exchange Consideration conversion offer, and one must assume that bondholders who elected for conversion to CoCos, failing which Exchange Consideration, will wish to dump their newly acquired equity as soon as possible.
    Former HBOS holders can breath a sigh of relief in some instances. For example, the 6.0884 hybrid was nearly impossible to sell for several months earlier this year – then it rallied from circa 20 to circa 50 by end September – then up to 75 prior to people accepting conversion. The replacement 7.5884 CoCos ought to trade above 80, a great platform for selling and de-risking whilst there is increased interest in the new bonds.

    Posted on: 19/11/09 | 12:00 am
  9. James Wilson says:

    For those looking for information on the new Lloyds ECNs / CoCos there is a great free online resource at:

    http://www.fixedincomeinvestments.org.uk/

    Posted on: 20/11/09 | 12:00 am
  10. canucklehead says:

    hey, great article!!

    for the bondholders that contemplated the exchange (or did the exchange), what is the real effective negative? seems like you are getting higher coupon that actually pays interest and has a fixed maturity date in exchange for a nearly zero coupon perpetual.. seems like the downside with either Tier 1 or Cocos is a good chance of being wiped out. so why not take far better near-to-medium term  outlook.

    unfortunately, i don't have access to lloyd's bond prices. were they much better than RBS' prior to this coco initiative…. author makes good point that lloyd's was part of the solution as well, whereas RBS was not.

    Posted on: 23/11/09 | 12:00 am
  11. Ben Lord says:

    Bill (and Commissariat, less directly),

    This is exactly the problem we have. The ECNs' share price if converted have been fixed at the current share price of c.90p (after a very long and perhaps over-done rally) multiplied by the number of shares that get you to exchange value. So the exchange would happen at a fixed historic share price.

    One of the things that worry us most about these 'bonds' is that IF Lloyds core tier 1 capital starts to fall and gets to, say, 7.5% or 7%, then these bonds will start to trade with an increasingly positive correlation to equity. So, given concern about capitalisation again, shares would start to fall in value. And holders will start to short sell Lloyds shares to cover their potential equity exposures. And then, finally, when conversion is forced upon holders at 89p per share, I think the shares are likely to be worth substantially less than that. That is why in many, very important, ways these could easily be called death spiral notes.

    Commissariat: I agree with you, that if you were a holder of old tier 1 notes or preference shares, you would tender because you keep getting coupons and the coupons are higher than the old bonds. But that's precisely why the 'bonds' have been designed as they have been; to entice people into them. In other words, to convince people to buy the 'note' and simulataneously sell the option to existing shareholders and regulators (and HMT!) that enables automatic conversion (at the worst possible time). I believe that the promise of 2 more years' coupon payments and 2% higher coupons perhaps undervalues this option. But we will see. Ultimately it depends on how remote the possibility of conversion is.

    Canuckle Head: if you were a holder and had the chance of exchange, I think there is no reason not to have tendered and see if you got exchanged if you think the chance of forced conversion is sufficiently remote. But if you think there is the chance of conversion down the line, then you might forego 2 years' coupons and the higher yields offered and neglect to sell the conversion option to the issuer / regulator / HMT. You then have the chance that in a few years the CoCo's convert to shares, and this new capital is enough to see the company through, and you remain as a bond getting coupons and principal back. On balance, though, given I think there's a chance of a death spiral, I would have tendered. 

    Posted on: 26/11/09 | 12:00 am
  12. Ben Lord says:

    Bill (and Commissariat, less directly),

    This is exactly the problem we have. The ECNs' share price if converted have been fixed at the current share price of c.90p (after a very long and perhaps over-done rally) multiplied by the number of shares that get you to exchange value. So the exchange would happen at a fixed historic share price.

    One of the things that worry us most about these 'bonds' is that IF Lloyds core tier 1 capital starts to fall and gets to, say, 7.5% or 7%, then these bonds will start to trade with an increasingly positive correlation to equity. So, given concern about capitalisation again, shares would start to fall in value. And holders will start to short sell Lloyds shares to cover their potential equity exposures. And then, finally, when conversion is forced upon holders at 89p per share, in many scenarios the shares are likely to be worth substantially less than that. That is why in many, very important, ways these could easily be called death spiral notes.

    Commissariat: The market agrees with you that if you were a holder of old tier 1 notes or preference shares, you would tender because you keep getting coupons and the coupons are higher than the old bonds – as illustrated by the heavy take up of the tender offer. But that's precisely why the 'bonds' have been designed as they have been; to entice people into them. In other words, to convince people to buy the 'note' and simultaneously sell the option to existing shareholders and regulators (and HMT!) that enables automatic conversion (at possibly the worst time). I believe that the promise of 2 more years' coupon payments and 2% higher coupons perhaps undervalues this option. But we will see. Ultimately it depends on how remote the possibility of conversion is.

    Canuckle Head: if you were a holder and had the chance of exchange, I think there is no reason not to have tendered and see if you got exchanged if you think the chance of forced conversion is sufficiently remote. But if you think there is the chance of conversion down the line, then you might forego 2 years' coupons and the higher yields offered and neglect to sell the conversion option to the issuer / regulator / HMT. You then have the chance that in a few years the CoCo's convert to shares, and this new capital is enough to see the company through, and you remain as a bond getting coupons and principal back. On balance, though, even given there's a chance of a death spiral, I would agree with the market's decision to tender.

    Posted on: 27/11/09 | 12:00 am

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