UPDATE 3-Lloyds offers investors deal to swap bonds, cash out

* Lloyds to swap up to £5 bln of bonds from institutions

* Bank offers to cash to retail investors for their bonds

* Bonds helped save Lloyds in 2009, but capital rules haveshifted

* Lloyds to take £1 bln charge, saves on interest payments

By Aimee Donnellan and Steve Slater

LONDON, March 6 (IFR) - Lloyds Banking Group is offeringbondholders who helped rescue it five years ago the chance toswap their holdings into new debt or cash out now in case thebonds get called at par.

Faced with investor outcry after saying last month it couldbuy back £8.4 billion ($14 billion) of bonds at face value undernew capital rules, Lloyds held out an olive branch Thursday.

The lender is offering institutional investors thechance to swap up to £5 billion of their bonds for the newinstruments in euro, dollars and sterling. Retail holders arebeing offered cash.

Britain's financial regulator encouraged Lloyds to offerretail investors cash as a way to exit, as the watchdog is keenfor the general public not to hold complex instruments, peoplefamiliar with the matter said. The Financial Conduct Authoritydeclined to comment.

New European banking regulations mean the existing bonds areunlikely to count toward capital buffers - and under the termsof sale, that would allow Lloyds to call them at face value.

But the bank, which is still 33% owned by UK taxpayers, metwith a furious reaction when it surprised investors last monthby saying it might do so.

Mark Taber, a campaigner for retail bondholders, last weekwrote to Lloyds calling the move "irresponsible andshort-termist".

Instead, the new proposal gives the bank's 120,000 retailinvestors the chance to cash out - a move that also offersLloyds a way to avoid hurting its chances for raising funds infuture.

"This is a very Lloyds-like deal," Neil Williamson, head ofEMEA credit research at Aberdeen Asset Management, told IFR.

"It is not a giveaway, nor are they invoking all theircontractual rights. They could have called the bonds at par butinstead they are using the potential regulatory call at par as astick for the future, while giving investors a chance to getout."

COMING TO TERMS

The existing bonds, known as enhanced capital notes (ECNs),are now seen as relatively low risk instruments, with anattractive annual interest of 6%-16%.

They had been trading at a premium, but their value fell upto nine points after last month's warning from the bank.

The bonds rallied as much as four points Thursday after theexchange offer was announced.

Now it is offering to swap them for new Additional Tier 1instruments that will convert into Lloyds shares if the bank'sCommon Equity Tier 1 ratio falls below 7%.

The ECNs only convert if core capital falls below 5%.

Lloyds will take an accounting charge of about £1 billion inthe first half of this year, based on a full take-up of theoffer. That would knock 0.4 basis points off its Common EquityTier 1 ratio.

But it will save money from lower future interest payments,which it said would boost net interest margin by 5 basis pointsthis year.

It will pay annual interest of between 6.375% and 7.875% onthe new bonds, compared to an average coupon of 9.3% on the ECNs- a savings of more than £150 million a year.

FAIR OR NOT?

Lloyds said the offers was made at "a price consistent withcurrent trading prices," although many of those prices havefallen in the last three weeks.

Retail investors are being offered premiums of 6-14% on mostof the bonds.

"The cash offers look a bit low on some of them, which whencombined with the implied threat to try and scare you - peoplewill feel there's a bit of bully-boy stuff going on here, Ithink," Taber, the campaigner, said on Thursday.

One banker said: "This is basically an offer a bank makesjust before they stick the knife in."

Additional Tier 1 bonds are first in the line of fire ifLloyds runs into difficulty, which could lead to coupondeferrals.

Despite the riskier elements of these trades, though,investors have been scrambling to buy similar deals from thelikes of Nationwide and Barclays.

Lloyds, which last month reported a profit for the firsttime in three years, is not the first bank to harden its stanceon high-interest paying bonds that may no longer have any use inbolstering capital. Credit Suisse last month fired asimilar warning shot.

Lloyds has hired a large team of banks to assist; they areBank of America Merrill Lynch, Lloyds, Goldman Sachs, Barclays,Morgan Stanley Deutsche Bank and UBS, Barclays, BNP Paribas,Citigroup, Credit Agricole CIB, Credit Suisse, HSBC, JP Morganand Morgan Stanley on the dollar.