One of the attractions for me of owning shares in Lloyds (LSE: LLOY) is the income potential. As a large bank, it has shown it can be massively profitable.
Last year, for example, post-tax profits came in at over £100m a week. As a customer suffering from high transaction charges and branch closures, I cannot say I like the bank’s strategy.
But, clearly, it can be highly profitable. The annual Lloyds dividend was recently increased by around 20%. The shares currently yield 4.7%.
But how secure is that dividend, for example if the housing market really starts to struggle? After all, Lloyds is the country’s biggest mortgage lender.
Default risks
History can help us here – but not completely. During the financial crisis, Lloyds cut its dividend and It took years for it to be restored. Even today, it is far below the level it was back then. That is one more reminder, as if any were needed, of how a bank can be negatively affected by a tough economy.
People start to default on their loans at the same time property values drop. So a bank can be left unpaid while holding assets worth less than they were. That happened to Lloyds – and most of its competitors – during the financial crisis.
But while the underlying pattern is unlikely to change, it is worth noting that the Lloyds of today is not the same bank as it was in 2008. The bank has tightened its risk controls since then. So whenever the next housing market crash comes, Lloyds should be better prepared than was last time around.
Gathering storm
Lloyds has been at pains to point out its asset quality and low level of defaults over the past few quarters.
Looking at its annual results published last month however, there is an underlying impairment charge of £1.5bn. The year before, that number had been a credit, although that partly reflects the unpredictable economic environment of the pandemic era.
What is clear however, is that a £1.5bn impairment charge is sizeable. Indeed, it is part of the reason the bank’s statutory post-tax profit fell 6% compared to the prior year. It remains huge. But if this year’s impairment charge grows again, it could further weaken profits.
Lloyds dividend coverage
In some ways that might not matter too much for the Lloyds dividend. Of the £5.6bn post-tax profit, only around £1.6bn will be used to pay dividends. So even after the large increase in the payout, it is comfortably covered by earnings.
In fact, one reason I sold my Lloyds shares last year was because I felt management was not distributing as large a share of profits as I would like in the form of dividends. The Lloyds dividend is still below its 2019 level.
That caution does give the firm a sizeable cushion though. Even if profits fall sharply, they could still be large enough to support the dividend at its current level.
However, if a crash drives loan defaults up enough, the dividend might not be sustainable. In a crash, banks could also be mandated by their regulator to suspend dividends. Lloyds has already done so twice this century. No dividend is ever guaranteed — including at Lloyds.
