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The Surprising Buy Case For Lloyds Banking Group PLC

Today I am looking at an eye-opening reason why a steady improvement in net interest margins bode well for shares in Lloyds Banking (LSE: LLOY) (NYSE: LYG.US) to head skywards.

An excellent margin call

Lloyds Banking’s net interest margin (NIM) — or the difference between the interest income Lloyds generates, and the interest the bank pays to its customers — has steadily improved in recent times, the bank benefitting from subdued interest rates offered to savers across the banking sector.

Lloyds announced out in August’s half-yearly report that its group NIM rose to 2.01% in January-June, beating expectations and representing a significant improvement from 1.93% in the corresponding 2012 period. This excellent progress has seen the bank increase its NIM target for 2013 to 2.1% in August’s financials, from 1.98% in March.

As Investec points out, the improvement in the firm’s NIM ratio has been pushed by lower rates paid to savers rather than blistering activity in the mortgage market — indeed, the broker indicates that it executed net negative mortgage lending again during the first six months of 2013.

Investec also reflects that “retail depositors evidently perceive that they have nowhere to run, and an element of “terming out” appears to have only modestly softened the impact on their returns”, a situation unlikely to  change in the near future as meagre savings rates look set to reign across the industry for the foreseeable future.

On top of this, the bank has executed what it deems an “impeccably timed repositioning of Lloyds’ structural interest rate hedge”, which the broker says could be responsible for around half of the bank’s increase in margin guidance for 2013.

Lloyds grabbed the headlines last month after the British government decided to cash in on steady price strength and dispose of 6% of its holding in Lloyds Banking. The move now leaves the taxpayer with a 32.7% stake in the part-nationalised bank, and has added to speculation that the bank is ready to start shelling out dividends again sooner rather than later.

Indeed, City analysts expect a dividend of 0.67p per share to leap to 2.2p next year, payment which carry yields of 0.9% and 3.2% correspondingly. With the firm’s transformation plan ready to deliver stunning earnings growth over the medium term — losses per share of 2p last year are expected to turn into earnings per share of 5.2p and 6.7p in 2013 and 2014 — I believe that shareholders can expect dividend income to move steadily higher looking ahead.

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> Royston does not own shares in Lloyds Banking Group.