7% forward yield and strong coverage! I think Lloyds shares are a steal

Dr James Fox explains why he sees Lloyds shares as one of his key holdings, noting a strong forward yield forecast and impressive coverage.

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I started topping up on Lloyds (LSE:LLOY) shares in March when the US banking fiasco engendered panic throughout markets. And I’m continuing to do so. This banking giant has one of the best forward dividend yields and great coverage.

It’s not just me

Lloyds has a host of ‘buy’ ratings, and as far as I’m aware no ‘sell’ positions. Royal Bank of Canada has a price target of 70p, while Berenberg Bank‘s is 58p. Before being swallowed up by UBS, Credit Suisse had Lloyds as its ‘Top Pick’.

And these ratings are broadly supported by discounted cash flow calculations. At the current price, Lloyds could be undervalued by as much as 50%, representing a huge upside.

Tailwinds and headwinds

Lloyds is more interest rate sensitive than many of its peers in the banking world. That’s because it doesn’t have an investment banking arm and it’s heavily focused on the UK mortgage market.

And that makes Lloyds an interesting proposition right now. With interest rates rising, banks are receiving higher net interest incomes. Lloyds is more exposed to this tailwind as it directly impacts the majority of its operations.

This is highlighted by its Q1 performance. The bank posted first-quarter pre-tax profit of £2.26bn, up 46% year on year, and better than the £1.95bn average of analyst forecasts. Net income, generated after deposit payouts, rose 15% to £4.7bn. These are outstanding numbers. Earnings per share were 2.3p.

However, there’s also a downside to higher rates — higher impairment charges. In Q1, Lloyds increased bad loan provisions to £243m — that was less than many expected. But with interests rates still rising, there could be more pain to come.

And as someone looking to buy a house, I can attest to the pressure this puts on customers. If I take what I’m being offered, the repayments will be £1,300 greater per month than they would have been two years ago. As such, slower loan book growth is also an issue in this higher rate environment.

Thankfully, the forecast is for rates to moderate. The sweet spot would be between 2% and 3%.

Forward yield

Lloyds currently offers a dividend yield of 5.4%. That’s strong. It’s stronger than all of its major UK banking peers, and far above the FTSE 100 average. But what makes it even more interesting is the coverage.

In 2022, the dividend was covered 3.04 times by earnings — meaning the company could pay its stated dividends more than three times from its income. This figure was down from 3.75 in 2021, but sits far above the benchmark number of two — a dividend covered at least two times is considered healthy.

This coverage, combined with continued strong performance, gives Lloyds the opportunity to boost its dividend going forwards. Analysts expect this to rise to 2.7p and 3p in 2023 and 2024 respectively, and it could go higher. Some analysts have forecast 3.1p for 2024.

And this is why I’m buying more. We’re looking at a forward yield of 7% and plenty of room for the share price to grow. It’s one of several very attractive buying opportunities I see right now.

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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