I’d build a second income with shares of this banking giant

Lloyds shares currently provide a dividend yield of 6.4%. This presents a potentially great opportunity for me to generate a second income.

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Right now, the market seems to be punishing certain companies that are doing well. This means a great chance for me to create a second income.

Lloyds Banking Group (LSE:LLOY) is one of these companies. Over the last six months, its shares have plummeted by 10%.

Some might look at it and think this is a bad investment. But income investors, like myself, see this as a good opportunity.

As the share price falls for a company, the cost to acquire its future dividend payouts becomes much cheaper. In the case of Lloyds, it’s now 10% cheaper than it was six months ago.

Why are the shares performing poorly?

I need to analyse why Lloyds seems to be out of favour.

The UK economy is struggling, not helped by the Bank of England raising interest rates to 5.25% in an effort to curb inflation. This has created concerns that more and more people will default on their loans and mortgages.

This isn’t good news for Lloyds as the UK’s largest mortgage provider. There are fears that it will have to write off more of its loans as the number of defaults increases.

Is this fear justified?

Looking at Lloyds’ interim results for 2023, however, I’ve noted that it set aside £662m as an impairment charge for any potential future defaults. This means it’s recognising defaults on loans and mortgages that haven’t even occurred yet. It’s also taken out of its final after-tax profit figure.

Any of this impairment charge that doesn’t materialise, will be credited back as other income in future accounts.

It looks as though Lloyds has already factored in any defaults into its results. However, I don’t believe the market has taken this into account when determining the value of the shares.

The problem with share prices in the short term is that they’re partly determined by market perception. Therefore, holding Lloyds shares carries risk. The market’s negative perception of the UK economy and the knock-on effects on the bank could drive its share price down further.

However, when market perception and reality differ, a golden opportunity arises. When the UK economy eventually improves, there will be much more optimism around the banking sector, which could lead to the shares soaring.

Furthermore, I don’t believe the dividend is in any danger, even if default levels are higher than expected. In the first half of 2023, the group generated an after-tax profit of £2.86bn. It only paid out £590m in dividends. This shows that there’s plenty of cover for its dividend and also ample room for Lloyds to continue growing its dividend, as it did by 15% in the first half of 2023.

How I’d generate a second income

The shares are currently trading for 43.5p apiece. With a dividend yield of 6.4%, I could generate an extra income of £1,000 annually by buying 35,920 of its shares.

It’s important to keep in mind that dividends aren’t guaranteed, but this looks very enticing to me.

Moreover, Lloyds shares are trading at extremely cheap levels, sporting a price-to-earnings (P/E) ratio of 5.5. This makes the dividend look like an even bigger bargain.

Therefore, if I had the spare cash, I’d buy Lloyds shares today.

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.

Muhammad Cheema has no position in any of the shares mentioned. 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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