LONDON, Feb 20 (Reuters) - Lloyds Banking Group risks a revolt among retail investors and also hedge funds and institutions after warning it may buy back on the cheap high-interest bonds that helped rescue the bank in the financial crisis.
Lloyds, 33 percent owned by the UK taxpayer, told investors last week the 7.5 billion pounds ($12.5 billion) of bonds it issued to strengthen its capital in 2009 are now unlikely to count towards its capital buffers under new European rules, potentially making them worthless.
Lloyds said it could "call" them or buy them back at near their face value, sending the value of the bonds tumbling.
With more than 100,000 retail investors holding them, Lloyds could face a legal challenge, making it "very messy" for the bank, Mark Taber, a campaigner for retail bondholders, said. Taber has already led successful campaigns for retail bondholders in Bank of Ireland, Co-operative Bank and Lloyds in the last five years.
"Lloyds were surprisingly aggressive in the tone they took, and since then I've had a lot of calls on it," Taber said.
Lloyds, which last week reported a profit for the first time in three years, is not alone in hardening its stance on high-interest paying bonds that may no longer have any use in bolstering capital. Credit Suisse this month fired a similar warning shot.
Banks, eager to increase earnings and dividends, are having to look at all options to improve margins in a low interest rate environment.
"As regulators are becoming clearer and old-style (bonds)instruments are increasingly expensive to maintain, regulatory calls are getting more and more attractive to issuers," BNP Paribas credit analyst Gildas Surry said in a note this week.
He estimated the bonds cost Lloyds about 417 million pounds a year. It could cost the bank 470 million pounds to buy all the bonds back at market values, he said, or less if it offers a lower price.
But upsetting bond investors could backfire by raising banks' funding costs in the future.
Taber said ideally, Lloyds would not take too hard a line. "I'm sounding people out ... there could well be groups forming on this. There are a lot of people they will upset if they take too aggressive approach."
How retail investors are treated will be a key issue. Many are pensioners who got the bonds in exchange for bonds from Halifax or Cheltenham & Gloucester that became part of Lloyds. Some of these pay the highest interest, meaning they could be hit hardest.
Hedge funds and other big investors are also watching the issue closely and lawyers are looking at the terms, one hedge fund manager said. He said if Lloyds takes an aggressive stance it would become a "hot issue" between investors and both the bank and the UK regulator.
Lloyds issued the bonds in December 2009 in exchange for a series of old bonds. The new bonds were designed to boost the bank's capital if it ran into trouble and formed part of a broad rescue deal for Lloyds that aimed to cut the cost to taxpayers.
They pay interest of between 6 percent and 16 percent a year and because of these interest rates have traded at a significant premium to their face value.
New UK and European capital rules in force this year mean the bonds may no longer count as so-called "stress test capital" that can be called on if a bank hits trouble.
But it is not clear how the Lloyds' bonds are affected.
The bank has said the risks of holding the bonds were well known. "You'd have to be blind and deaf not to know that there was a regulatory par call option in these instruments," Charles King, Lloyds director of investor relations, said on a call with investors following the bank's 2013 results.
But Taber disagreed with this view, given the complexity and uncertainty around the bonds. "How you can expect the average retail investor to be on top of all this? Lloyds still don't know the answer, they are waiting for the (UK regulators) to clarify what the 2014 stress testing is and whether these qualify. It's so complicated," he said.
There are 33 types of the bonds and Lloyds said it could treat each one differently.
The bank could buy the notes back at par, but credit analysts said it would be more likely to offer a premium - somewhere between par and where the bonds trade in the market, which for most is between 106-113 percent, and higher for some.
King said if the bonds ended up not counting for "stress testing" then the bank's management almost had a duty to shareholders to consider the economic value that would create.
He added: "I wouldn't call myself investor friendly, but I would call myself fair. And I don't see myself deviating from that adjective any time soon."