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CoCo stops

10 December 2015 By George Hay

Lloyds Banking Group has an early Christmas present. The UK’s Court of Appeal ruled on Dec. 10 that the British bank could buy back redundant contingent convertible notes at their par value. It removes an irritant for Lloyds – but should also make CoCo issuers in general feel more relaxed.

On the face of it, fretting about CoCos should be the preserve of yield-hungry investors. If a bank’s capital ratio drops below a certain trigger point, they face losing juicy coupons exceeding 10 percent when their holdings convert into equity or are written down to nothing. But banks that have issued the $201 billion (133 billion pounds) of CoCos and Additional Tier 1 instruments have thus far also faced an uncertainty. If regulatory norms shift, the capital may become both superfluous and expensive.

This is where Lloyds found itself. The bank had 3.3 billion pounds of so-called enhanced capital notes left over from its 2009 bailout, which enabled it to avoid becoming even more heavily state-owned. But banks’ capital-build since the financial crisis rendered the bonds’ 5.1 percent trigger point useless as capital. Regulators nowadays get antsy if a bank’s core Tier 1 ratio falls below 7 percent. That helps explain why the notes did not feature as part of Lloyds’ capital in a 2014 UK bank stress test.

Before Dec. 10, the simplest solution for Lloyds – buying the bonds back at par – had looked a non-starter. A UK High Court judge ruled in June that ineligibility for the stress test did not equate to a capital-disqualification event, which would have allowed a par repayment. As such, Lloyds faced an unappetising choice between buying back the bonds at 110 percent of par, or hanging on to them and paying 200 million pounds a year in interest.

The fact that the Court of Appeal has overturned the June ruling means that investors who hold the bonds lose out. What Lloyds gains in extra earnings could be partially offset by a hit to its solvency position, Citi analysts reckon. But insofar as the judgment implies CoCo issuers will have flexibility in offloading useless capital, issuers in general will be encouraged.

 

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