June 24, 2011 - 7:50pm EST by
2011 2012
Price: 91.00 EPS NA NA
Shares Out. (in M): 67,075 P/E NA NA
Market Cap (in $M): 29,461 P/FCF NA NA
Net Debt (in $M): 0 EBIT 0 0

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Lloyds Banking Group ("LLOYDS" - Bond Ticker)
Investment Thesis
The Lloyds Enhanced Capital Notes ("ECNs") represent a good risk-reward at current levels. With prices in the low 90s, the 8% (XS0471767276) and 8.5% (XS0471770817) ECNs yield close to 10%. These securities are cheap to high yield, other comparable EU bank paper and similar Lloyds Lower-Tier 2 securities.

Why does the opportunity exist?

-European sovereign concerns
-Off the run bonds (ECNs are unknown to many investors)
-Ratings are below investment grade
-Excluded from indexes
-Hedge fund selling / no stable investor base
-Equity conversion possibility

After large impairments in 2008-2010, Lloyds should be profitable in 2011. Pre-tax profits before impairments along with a Tier 1 ratio of 10% should buffer any increased loan loss provisions (Ireland / UK housing). Despite recent share price declines, higher earnings are expected in 2011 and 2012.  

Company Description
Lloyds is the #1 retail bank in the UK with estimated market shares of 25% and 19% for personal current accounts and mortgage lending. As a result of the acquisition of HBOS, the company required government support. Currently, the UK treasury owns 41% of Lloyds' shares. While there have been rumblings about the government selling its stakes in Lloyds and RBS in 2012, nothing has been confirmed.

As of March 31, 2011, Lloyds reported Core Tier 1 and Tier 1 ratios of 10.0% and 11.4%, respectively. For background, the core capital ratio is consists of equity capital and declared reserves (£39 BN) divided by risk-weighted assets (£391 BN). Risk-weighted assets are total assets recalculated to a smaller number to reflect the relatively low-risk nature of certain assets. Preferred stock (i.e. Tier 1 capital) is added to core capital to calculate the Tier 1 ratio. Finally, there is Tier 2 capital which is comprised of undated (upper tier 2 - UT2) and dated (lower tier 2 - LT2) subordinated debt. The ECNs are Tier 2 capital. Total size is currently ~£9 BN.

ECN Summary
The Lloyds ECNs came into existence during an exchange offer announced in November 2009 when existing Tier 1s and UT2s were exchanged into new securities with 150-250 bps coupon steps. Concurrently, the company completed a £13.5 BN rights offering. Unlike Tier 1s, the ECNs carry a mandatory coupon.

To be more regulatory-friendly, the ECNs have a 5%* Core Tier 1 trigger, which results in a conversion to equity at a pre-determined price. Therefore, in the very unlikely scenario that Core Tier 1 ratio falls below 5%, the ECNs are converted to equity at 59p**. Note that newer ECNs are structured with 7% equity triggers.

*Basel II definition; Basel III, but will be more stringent.

**If we are converted and the stock trades to previous low of 20p, the implied recovery is 34 cents. Again, this appears remote.

The UK resolution regime likely makes this trigger a moot point as a change in the law already allows LT2 to be written off upon banks ceasing to be viable. Additionally, Basel III requires a 7% Core Tier 1 ratio, which makes a decline below 5% unlikely. A bank like Lloyds will likely have raised new capital before this level is breached. I imagine there is a remote risk of a writedown in the event of significant and rapid loan loss provisions, but net, net, I do not think the conversion language is much of a risk - at least relative to other LT2s.

The notes I am recommending are slightly different than most of the Lloyds ECNs. These ECNs are LT2 and have a fixed maturity. The 8% and 8.5% ECNs yield 50-100 bps more and were issued via bilateral exchanges with large holders. The 8%s and 8.5%s were structured slightly differently for technical reasons (LT2 bucket full) - as UT2 which are perpetual in nature. The UT2 ECNs are callable in 2020 and 2021 and have steep incentives to call. If not called, these securities switch to a floating rate coupon of US Libor + 640.5 bps and US Libor + 692.1 bps. Between these high steps and the current swap curve, it is unlikely these notes remain outstanding post call. I believe that was the intent when the notes were structured. Furthermore, my understanding is that under Basel III these notes will not even count as UT2 due to its incentive to redeem at the call date. As a result, I assign a very small probability to these notes not being called (certainly less than a 50-100 bps discount).

In the annual report, Lloyds notes "minimal direct exposure to the national and local governments of Portugal, Ireland, Italy, Greece and Spain."

The biggest risks are the Irish book and UK housing prices. The Irish loan book (gross £28 BN) is split between commercial real estate (43%), corporate (29%) and residential (28%). The total book is currently marked in the high 60s (impaireds in mid-40s) as a result of impairments already taken. Even if I mark the loans down another 20% and assuming no offsetting income, the Core Tier 1 ratio remains above 9%.

As the market share leader in UK mortgages, Lloyds is exposed to UK housing prices. Current LTVs are ~55%, but LTVs >100% = £46 BN. Most of these loans are current with only £3 BN over 90 days delinquent. Unlike in many US states, UK mortgages are not non-recourse. If I assume a 20% loss on the >100 LTV loans, the Core Tier 1 ratio falls to the high 7%s. If I assume both scenarios occur, the Core Tier 1 ratio falls to the high 6s. Again, this is before any profits are used to offset the losses. The estimated £10 BN+ of pre-impairment profits should help cushion any unforeseen impairments.

Despite limited exposure to Greece, these securities traded down almost 8 points from highs. Compared to the high yield market and other UT2s/LT2s, the near 10% yield is an attractive risk-reward. Compared to Lloyds LT2 (6.5% due 2020 yielding 7.25% / rated Baa2/BBB+), these securities are 200+ bps cheap.
-Higher-than-expected Irish losses
-UK housing declines
-Continued European sovereign concerns and contagion (should be more mtm risk)
-Volatility if hedge funds continue to exit




-Continued coupons
-Greece rescue
-S&P upgrade to investment grade
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