A multi-billion-pound reason to buy boring Lloyds shares!

Dr James Fox takes a closer look at Lloyds shares and why he expects a very lucrative tailwind to continue for several years.

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Lloyds (LSE:LLOY) shares were my top pick on the FTSE 100 in the latter half of 2022. But going forward from here, I’m still bullish on this UK-focused bank.

So let’s take a closer look at why that is.

Rates tailwind

Interest rates have been rising, and there’s reason to expect that the Bank of England will increase rates further in the coming months. To date, interest rate rises have largely been positive for banks, although there certainly are downsides.

In its full-year results, published in February, Lloyds said net income had risen 14% to £18bn, on the back of higher interest income in 2022.

Net interest margin — the difference between lending and savings rates — rose 40 basis points to 2.94% in 2022. For 2023, Lloyds is targeting more than 3.05% as savings rates rise slower than lending rates.

It’s also important to highlight that Lloyds is also earning more from its central bank deposits. Analysts have suggested that Lloyds could be pulling in around £3bn a year in extra revenue from its £145.9bn of eligible assets and £78.3bn held as central bank reserves.

Higher for longer

Higher interest rates are good for banks, until they’re not. The near-term forecast is for more hikes. That’s because inflation is stickier than anticipated. There’s also increasing pressure on wages that could lead to the dreaded wage-price spiral.

Equally, it’s worth noting that the UK economy may be deemed too weak to absorb large rate rises. Many analysts are seeing the base rate stopping well short of 5%, but falling slowly to 3% or 2.5% over the next five years.

Broadly speaking, I see this as fairly positive. The current base rate is 4% and, in the short run, further increases may not be beneficial as customers could struggle to make loan repayments. And while interest income may increase, it’s likely to push demand for borrowing downwards.

However, the medium-term forecast looks more positive. A base rate around 2-3.5% is far above the average for the last decade. And under improved economic conditions, Lloyds could see net interest income remain high, while impairment charges fall.

This could be optimal for Lloyds, delivering billions in extra revenue with bad debt falling. In 2022, impairment charges for potential bad debts surged to a staggering £1.5bn.

Reasons to buy

Firstly, as noted, the above forecast should be positive for banks, and I’d expect to see Lloyds become more profitable over the decade. And with the bank trading with a price-to-earnings ratio of just 7.1, it looks like great value. That’s half the index average.

The dividend also sits at an attractive 4.6%, but with a confirmed increase from 2p to 2.4p per share, the forward yield is higher. City analysts have forecast 2.7p for 2023 and 3p for 2024. With a current dividend coverage ratio around three, there’s certainly room for sustainable dividend growth.

I’m aware that some investors don’t like the bank’s UK focus. All its sales come in the UK and that makes it vulnerable to any downward trends in the British economy. But this doesn’t bother me. In fact, I’m actually pretty bullish on a more pragmatic Britain.

I’ve frequently topped up my position in Lloyds, and will buy more.

Should you invest, the value of your investment may rise or fall and your capital is at risk. Before investing, your individual circumstances should be assessed. Consider taking independent financial advice.

James Fox has positions in Lloyds Banking Group Plc. The Motley Fool UK has recommended Lloyds Banking Group Plc. Views expressed on the companies mentioned in this article are those of the writer 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 diverse range of insights makes us better investors.

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