LLOYDS BANKING GROUP PLC Lloyds 9.25 Preferreds
November 08, 2018 - 3:28pm EST by
cfavenger
2018 2019
Price: 140.50 EPS 0 0
Shares Out. (in M): 300M P/E 0 0
Market Cap (in $M): 300M P/FCF 0 0
Net Debt (in $M): 0 EBIT 0 0
TEV ($): 0 TEV/EBIT 0 0

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Description

Lloyds 9.25 Perpetuals (LLPC Pfd ISIN: GB00B3KS9W93)
 
We are investors in financial sector securities with a focus on Bank preferreds and Sub debt.
 
Lloyds 9.25 are irredeemable non-cumulative preferred shares. They are currently trading at a price of
140.5 and offer a current yield of 6.7% in GBP or 8.5% swapped into USD. Due to circumstances we
explain in this writeup, we believe Lloyds 9.25 have a price floor in the 130s. We also think Lloyds is
likely to tender for these securities at a price around 150 in early 2019, offering a total return of 15-20%
on a capital instrument from a strong issuer.
 
In March, a peer UK institution committed a comedy of errors which spooked the market with concerns
that these irredeemable securities were in fact callable. Despite these fears being refuted, the Lloyds
9.25s remain down nearly 20% from their early March level. As a result, we believe these securities
offer attractive risk-adjusted yield and the opportunity for capital appreciation.
 
On March 8th 2018 Aviva PLC alerted its investors that it could in theory, use a court sanctioned process
called a “reduction of capital” to redeem its own irredeemable preferred shares at par plus accrued
interest and arrears. Subsequently, its outstanding irredeemable preferred shares collapsed. For
example, AVLN 8.75s fell from 175 to about 120. Other irredeemable preferred shares didn’t fare much
better as fear spread that issuers would make use of this mechanism to rid themselves of these high
coupon liabilities. If employed, the reduction of capital mechanism would have relied on a simple assets > liabilities test to
upstream capital from the subsidiary to holdco, despite the “irredeemable” label on the tin. Of course,
this is not how things played out…
 
On the 12th of March 2018, Ecclesiastical, another issuer of irredeemable preferred shares that they had
“no plans to cancel [their own] preference shares…”, while bank issuers of these shares generally stayed
quiet. The mark to market losses in retail, pensioner and institutional accounts created an uproar in the bond
market that forced Aviva to issue a statement on the 23rd of March that they had “decided to take no
action to cancel [their] preference shares.” and would not approach this subject again until 2026, at
which point they would take “into account the fair market value of the preference shares at that time”.
However, even that was not enough and Aviva eventually had to offer a discretionary goodwill payment
to holders who sold preference shares between March 8th and March 22nd. In other words, Aviva
retroactively made sellers whole.
 
We do not believe this was done out of the kindness of Aviva’s heart. Rather, this was most likely necessary to forestall a full blown political crusade in the UK against Aviva.
 
Unlike Aviva and Ecclesiastical, none of the bank issuers made any public announcements regarding
their intentions towards the irredeemable preferred shares. After weeks of deafening silence, the FCA,
under much pressure by British MPs, sent out a letter to the banks encouraging them to publish any
updated information on the terms of and recent considerations concerning the irredeemable preferred
shares. This opened the door for the banks to comment publicly on them. Lloyds took the opportunity
and commented that they had “no plans to use a capital reduction to cancel the irredeemable
preference shares.”. In other words, Lloyds has already publicly stated that the 9.25s will remain
outstanding in the foreseeable future. We find additional comfort in the thought that, given the UK
markets’ ongoing sensitivity to bad behavior from banks Lloyds executives would find themselves right
back in the firing line if they announced that they were even considering a redemption at par.
Before the Aviva announcement, the Lloyds 9.25 were trading at about 178, today they are at 140.5.
This is despite Lloyds having affirmed that they will not redeem these securities at par.
 
These securities lose their Additional Tier 1 capital treatment at the end of 2021. After this, they will
only count as Tier 2 capital. Paying a 9.25 coupon on Tier 2 Capital is extremely expensive for Lloyds as
5-year Lloyds subdebt in GBP is currently trading at a 3.2% yield to maturity, indicating that Lloyds could
issue Tier 2 significantly cheaper.
 
The only way for Lloyds to retire this security at this point would be to tender at a premium to the
current market price. Lloyds recently announced a buyback program for the common that will take
effect in 2019. We believe there will be a parallel buyback of these irredeemable preference shares and
other legacy capital instruments. A tender at 150 on the next coupon payment date (5/31/2019) would
result in a Yield to takeout of 17%. If the preferred shares were to fall further in price, we believe Lloyds
would take a very hard look at tendering sooner. In other words, we believe the Lloyds 9.25 have a price
floor somewhere in the 130s and would be happy to pay somewhere in the 150s to rid itself of a security
that has become more of a public relations disaster and will soon lose its capital benefit.We also
believe a price of at least 150 is necessary for Lloyds to avoid Aviva’s political and public relations
debacle of appearing to take advantage of retail investors.
 
We view Lloyds as a very strong credit, and this particular issue has among the highest current yields
among the irredeemable preferred shares (and really any fixed income instruments issued by large
banks in the UK) at 6.7% (tied with SANUK). Swapping back to dollars an investor can achieve a USD
current yield of 8.5%. The following securities are the closest comps (all irredeemable preferreds):
 
Lloyds 9.25 6.6%
Lloyds 9.75 6.5%
SANUK 10.375 6.7%
RBS 9 6.3%
ALLCH 8.5625 6.1%
AVLN 8.75 6.5%
 
We think that Lloyds is the best bank credit in the UK and should trade at a premium to RBS. On
average, Lloyds Additional Tier 1 (AT1) trades at a 20bp premium to RBS AT1. At 6.1% current yield
(20bp tighter than RBS 9) Lloyds 9.25 would be trading at 155, representing 10% upside from current
prices. Taking into account the relative cheapness, high coupon, high likelihood for a tender above
current market prices and high credit quality of the issuer we target a 15-20% total return from these
levels.
 
NOTE: We have a position in these securities

 

I do not hold a position with the issuer such as employment, directorship, or consultancy.
I and/or others I advise hold a material investment in the issuer's securities.

Catalyst

We believe Lloyds will tender for these securities in 2019 with a price of at least 150.

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    Description

    Lloyds 9.25 Perpetuals (LLPC Pfd ISIN: GB00B3KS9W93)
     
    We are investors in financial sector securities with a focus on Bank preferreds and Sub debt.
     
    Lloyds 9.25 are irredeemable non-cumulative preferred shares. They are currently trading at a price of
    140.5 and offer a current yield of 6.7% in GBP or 8.5% swapped into USD. Due to circumstances we
    explain in this writeup, we believe Lloyds 9.25 have a price floor in the 130s. We also think Lloyds is
    likely to tender for these securities at a price around 150 in early 2019, offering a total return of 15-20%
    on a capital instrument from a strong issuer.
     
    In March, a peer UK institution committed a comedy of errors which spooked the market with concerns
    that these irredeemable securities were in fact callable. Despite these fears being refuted, the Lloyds
    9.25s remain down nearly 20% from their early March level. As a result, we believe these securities
    offer attractive risk-adjusted yield and the opportunity for capital appreciation.
     
    On March 8th 2018 Aviva PLC alerted its investors that it could in theory, use a court sanctioned process
    called a “reduction of capital” to redeem its own irredeemable preferred shares at par plus accrued
    interest and arrears. Subsequently, its outstanding irredeemable preferred shares collapsed. For
    example, AVLN 8.75s fell from 175 to about 120. Other irredeemable preferred shares didn’t fare much
    better as fear spread that issuers would make use of this mechanism to rid themselves of these high
    coupon liabilities. If employed, the reduction of capital mechanism would have relied on a simple assets > liabilities test to
    upstream capital from the subsidiary to holdco, despite the “irredeemable” label on the tin. Of course,
    this is not how things played out…
     
    On the 12th of March 2018, Ecclesiastical, another issuer of irredeemable preferred shares that they had
    “no plans to cancel [their own] preference shares…”, while bank issuers of these shares generally stayed
    quiet. The mark to market losses in retail, pensioner and institutional accounts created an uproar in the bond
    market that forced Aviva to issue a statement on the 23rd of March that they had “decided to take no
    action to cancel [their] preference shares.” and would not approach this subject again until 2026, at
    which point they would take “into account the fair market value of the preference shares at that time”.
    However, even that was not enough and Aviva eventually had to offer a discretionary goodwill payment
    to holders who sold preference shares between March 8th and March 22nd. In other words, Aviva
    retroactively made sellers whole.
     
    We do not believe this was done out of the kindness of Aviva’s heart. Rather, this was most likely necessary to forestall a full blown political crusade in the UK against Aviva.
     
    Unlike Aviva and Ecclesiastical, none of the bank issuers made any public announcements regarding
    their intentions towards the irredeemable preferred shares. After weeks of deafening silence, the FCA,
    under much pressure by British MPs, sent out a letter to the banks encouraging them to publish any
    updated information on the terms of and recent considerations concerning the irredeemable preferred
    shares. This opened the door for the banks to comment publicly on them. Lloyds took the opportunity
    and commented that they had “no plans to use a capital reduction to cancel the irredeemable
    preference shares.”. In other words, Lloyds has already publicly stated that the 9.25s will remain
    outstanding in the foreseeable future. We find additional comfort in the thought that, given the UK
    markets’ ongoing sensitivity to bad behavior from banks Lloyds executives would find themselves right
    back in the firing line if they announced that they were even considering a redemption at par.
    Before the Aviva announcement, the Lloyds 9.25 were trading at about 178, today they are at 140.5.
    This is despite Lloyds having affirmed that they will not redeem these securities at par.
     
    These securities lose their Additional Tier 1 capital treatment at the end of 2021. After this, they will
    only count as Tier 2 capital. Paying a 9.25 coupon on Tier 2 Capital is extremely expensive for Lloyds as
    5-year Lloyds subdebt in GBP is currently trading at a 3.2% yield to maturity, indicating that Lloyds could
    issue Tier 2 significantly cheaper.
     
    The only way for Lloyds to retire this security at this point would be to tender at a premium to the
    current market price. Lloyds recently announced a buyback program for the common that will take
    effect in 2019. We believe there will be a parallel buyback of these irredeemable preference shares and
    other legacy capital instruments. A tender at 150 on the next coupon payment date (5/31/2019) would
    result in a Yield to takeout of 17%. If the preferred shares were to fall further in price, we believe Lloyds
    would take a very hard look at tendering sooner. In other words, we believe the Lloyds 9.25 have a price
    floor somewhere in the 130s and would be happy to pay somewhere in the 150s to rid itself of a security
    that has become more of a public relations disaster and will soon lose its capital benefit.We also
    believe a price of at least 150 is necessary for Lloyds to avoid Aviva’s political and public relations
    debacle of appearing to take advantage of retail investors.
     
    We view Lloyds as a very strong credit, and this particular issue has among the highest current yields
    among the irredeemable preferred shares (and really any fixed income instruments issued by large
    banks in the UK) at 6.7% (tied with SANUK). Swapping back to dollars an investor can achieve a USD
    current yield of 8.5%. The following securities are the closest comps (all irredeemable preferreds):
     
    Lloyds 9.25 6.6%
    Lloyds 9.75 6.5%
    SANUK 10.375 6.7%
    RBS 9 6.3%
    ALLCH 8.5625 6.1%
    AVLN 8.75 6.5%
     
    We think that Lloyds is the best bank credit in the UK and should trade at a premium to RBS. On
    average, Lloyds Additional Tier 1 (AT1) trades at a 20bp premium to RBS AT1. At 6.1% current yield
    (20bp tighter than RBS 9) Lloyds 9.25 would be trading at 155, representing 10% upside from current
    prices. Taking into account the relative cheapness, high coupon, high likelihood for a tender above
    current market prices and high credit quality of the issuer we target a 15-20% total return from these
    levels.
     
    NOTE: We have a position in these securities

     

    I do not hold a position with the issuer such as employment, directorship, or consultancy.
    I and/or others I advise hold a material investment in the issuer's securities.

    Catalyst

    We believe Lloyds will tender for these securities in 2019 with a price of at least 150.

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