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Lloyds (LSE: LLOY) shares aren’t always the most exciting FTSE 100, It is a British bank with a low risk appetite. In fact, Sir Antonio Horta-Osorio was knighted for his efforts to make the institution more stable and reduce its exposure to risky operations.
So why am I buying more Lloyds shares? let’s take a closer look.
yield improvement
Currently, Lloyds offers a dividend yield of approximately 4.2%. This index is above average, and I am quite satisfied with it.
However, City’s analysts are forecasting a full-year dividend of 2.4p in 2022, rising to 2.7p and 3p in 2023 and 2024 respectively. The figure for 2024 shows an increase of 25% from the current position.
This would mean that the forward dividend yield for 2024 would be 6.25%. To me, that’s very attractive, especially from a company that would have a relatively low risk profile.
These inflated dividend payments would be easily affordable. The dividend coverage ratio in 2021 was 3.8. This means that earnings can cover the stated dividend by 3.8 times. Generally, a yield above two is considered healthy.
interest rate sensitivity
Lloyds has no investment arm and because of its fund structure, it has a higher interest rate sensitivity than other banks.
This hasn’t been ideal over the past decade, as rates have been near zero. But now the rates are going up and the Net Interest Margin (NIM) is going up. The bank said that NIM was projected to reach 2.9% by the end of 2022, and it could increase further in 2023.
Furthermore, it can be a tailwind that lasts for some time. After all, mortgages are often fixed and customers taking out mortgages now will be stuck with higher rates for longer. Hedging strategies can also help magnify these gains.
Around 70% of the bank’s income comes from UK mortgages. Thus, changes in NIM have a disproportionately large impact on revenue generation. In some ways, this reliance on UK mortgages is not ideal. But, traditionally, it has been a fairly stable sector of the market.
It is also worth noting that Lloyds is earning higher interest on its deposits with the central bank. Analysts suggest that every 25 basis point increase is worth £200m in interest revenue.
discounted share price
Lloyds has been trading at a discount for some time now. In fact, some discounted cash flow models suggest the stock may be undervalued by as much as 55%. But, of course, the model is dependent on cash flow forecasts, and that can be challenging to forecast.
The discount could and probably does reflect concerns about the UK economy in the near term. The country has escaped a recession for the time being, but the forecast for 2023 is pretty flat. Many analysts are still predicting a recession.
Banks especially feel the slowdown. When the economy turns upside down, debt goes bad. And banks will have to respond by setting aside more money. In Q3, impairment charges rose to £668m from releases of £119m a year earlier as bad debt concerns escalated.
Hopefully not much money will be required. And it’s not that I’m discounting the impact of bad debt, but I do believe that higher interest rates will lead to higher returns in the coming years.
The post I’m Buying Lloyd’s Shares for a Juicy 6.25% Forward Yield! First appeared in The Motley Fool UK.
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James Fox holds positions in Lloyds Banking Group plc. The Motley Fool UK recommends Lloyds Banking Group plc. The views expressed on the companies mentioned in this article are those of the author and therefore may differ from the official recommendations we make in our subscription services such as Share Advisor, Hidden Winners and Pro. Here at The Motley Fool, we believe that considering a wide variety of insights makes us better investors.
Motley Fool UK 2023