Lloyds (LSE:LLOY) is a largely unloved FTSE 100 stock. British banks haven’t been widely popular with investors for some time, and there’s a number of reasons for this. But why do I think it’s a buy now? Let’s find out.
A decade of headwinds
Since the financial crisis, banks have had their wings clipped. Not only has the regulatory environment changed, central bank interest rates have been near zero. In turn, net interest margins (NIMs) — the difference between lending and savings rates — have suffered.
Moreover, banks are often seen as cyclical stocks because they reflect the health of the economy. And, since the Brexit vote, the UK economy has struggled. Research suggests that the UK economy could be 5% smaller today as a result of the vote.
Since the financial crash, its operations have been cut back considerably. Today, it is a much smaller institution than it used to be. It is also seen as more of a bellwether for the UK economy than other stocks. That’s because around 60+% of its income comes from UK mortgages. It also doesn’t have an investment arm.
So, because of the above, investors haven’t flocked to Lloyds.
A big reason to buy
The macroeconomic environment isn’t great, and that’s not good for credit quality. But there is one big reason why I’m topping up on the shares. And that’s the NIM (net interest margin).
Lloyds is one of the most interest rate sensitive banks in the UK. And this is due to its funding composition and business model.
The main reason for this sensitivity is the high ratio of interest income to total income. Lloyds doesn’t have an investment arm and business activities are funded primarily by customer deposits. In Q3, interest income accounted for 74% of total income — £3.4bn.
Looking at the year as a whole, Lloyds now expects its NIM to come in above 2.9%. That’s up from 2.5% at the end of the last financial year.
The NIM is rising because banks regularly fail to pass on their gains from rising Bank of England (BoE) rates to savers. Lloyds pays a meagre 0.5% on its main instant access savings account, yet the BoE base rate is now 3% — up 275 basis points this year.
In fact, it’s even making more interest on the money it leaves with the BoE. As of June 30, Lloyds had £145.9bn of eligible assets with £78.3bn held as central bank reserves. Analysts suggest that each 25 basis hike will add close to £200m in treasury income from holdings with the central bank.
With 11 hikes of 25 basis point already this year, Lloyds could be earning an additional £2.2bn in treasury income.
So despite setting aside £668m for bad debt provisions last quarter, it has one huge tailwind in the form of interest rates. That’s why I’m buying more.
