Lloyds Banking Group (LSE: LLOY) shares are among the most popular with smaller investors. Ignoring stamp duty and broker’s fees, £1,500 invested in the shares of the UK’s largest lender at the start of November 2021 would now be worth £1,235. This represents a fall of nearly 18%. By comparison, the FTSE 100 is down by 1% over the same period.
Although this is a disappointing performance, Lloyds has paid two dividends during the past year. These would have generated £64 of income, giving a yield of 4.3%.
Rising interest rates
Lloyds should benefit from an economy where interest rates are rising. Over the past 12 months, the Bank of England has increased interest rates seven times. At 2.25%, the base rate is now at its highest level since November 2008. Most economists are forecasting further increases.
Banks make their money by paying a lower rate of interest on customer deposits than they charge on loans to borrowers. This is called the net interest margin.
A look at the third-quarter results for Lloyds shows how upwards pressure on interest rates is starting to have a positive impact. Profit before impairment was £2.4bn, compared to £2bn for the same quarter in 2021. The net interest margin increased from 2.55% to 2.98%, and is forecast to rise further.
Loan defaults
But, it is wrong to assume that Lloyds will always benefit from rising interest rates. To understand why, it is necessary to consider borrowers who default on their loans. In an economy with rising interest rates, the repayments on variable rate loans will increase. Also, company earnings and household incomes will generally be lower. This increases the risk of non-payment.
Every quarter, Lloyds reviews its loan book and makes an assessment as to the recoverability of the amounts lent. A provision is then made in the company’s accounts for any bad or doubtful loans. An increase in this provision (a charge) will reduce Lloyds’ profit. Any reduction in the provision (a credit) will increase earnings.
Let us take a look at how the impairment provision has moved during each of the last four quarters.
| Q4 2021: | credit £532m |
| Q1 2022: | charge £177m |
| Q2 2022: | charge £200m |
| Q3 2022: | charge £668m |
This highlights a potential problem — the provision is now on the increase. Investors have been nervous that Lloyds, which is particularly exposed to the domestic economy, will suffer as a result of an expected recession. The bank owns Halifax, the UK’s largest mortgage lender. The number of customers defaulting on their mortgages will inevitably rise as interest rates go up.
What should I do?
I already own shares in Lloyds Banking Group and currently have a paper loss.
But, I am not going to sell. I am confident that over the coming months, the bank will weather the anticipated economic downturn, and the share price will reach pre-pandemic levels once more. There is also the attractive prospect of picking up a few dividends along the way.
