Is Lloyds Banking Group plc about to offer a 10% dividend yield?

In a Morningstar interview last week, Old Mutual star investment manager Richard Buxton put forth Lloyds (LSE: LLOY) as one of his top stocks due to a dividend that he and his analysts forecast will soon rise to 6p. Considering the bank’s share price today is at 66p, this would mean a dividend yield of around 10%.

Of course, the company’s shares would re-rate and this yield would fall, but it’s worth exploring all the same whether or not Lloyds could nearly double its dividend in the coming years from the current 3.05p annual payout.

Spoiler alert: it’s possible

Unlike many rivals that still have yet to fully shed the bad assets and huge regulatory fines that have constrained returns since the financial crisis, Lloyds is relatively unencumbered. Indeed, while competitors such as Barclays have been forced to slash dividends, Lloyds’ statutory earnings last year of 2.9p per share fully covered regular dividend payouts of 2.55p.

In addition, the company paid out a special 0.5p dividend thanks to higher than expected statutory profits and a sufficient regulatory capital position. At year-end the bank’s tier 1 capital ratio had risen to 13.8% even after dividend payments. This is beyond regulatory requirements and will give management plenty of breathing room to continue paying out the vast majority of earnings in dividends. Should capital buffers continue rising well above regulatory minimums it is also possible that shareholders will see further special dividends in the future.

But this is far from guaranteed

There are still a few things that need to go well in order for Lloyds to raise earnings, and thus dividends, to 6p in the near future though. For one, the bank will need to see an end to PPI claims payments. The mis-selling scandal has already bled the bank of £17bn in cash and it will be hoping that the £1bn allocated to repayments in Q3 will be the last.

The company will also need to make headway in slashing costs. The bank’s 2016 cost-to-income ratio may have been better than large peers at 48.7% but it was still higher than that of small challenger banks. Still, management has done well to bring the ratio down from 49.8% in 204 and 49.3% in 2015. There is still progress to be made though.

This is especially true as the bank’s revenue growth is non-existent. In 2016 net income fell from £16.8bn to £16.6bn year-on-year due to lower interest rates and lower returns across each of its three main divisions. And there is little prospect of net income rising significantly in the future given the BoE’s reticence to rate rises and Lloyds’ massive size. It controls round 25% of new mortgages and is by far the largest retail bank in the UK. This means cost-cutting will be the main method of improving profitability.

That said, Lloyds is in much better health than competitors with a great capital position and underlying return on equity consistently above 13%. If management can continue to cut costs and its newly acquired MBNA credit card business can boost earnings, annual dividends of around 6p are not at all inconceivable in the next three to five years.

Since the financial crisis dividends from banks have been consistent only in their ability to disappoint income investors. Thankfully the Motley Fool’s top analysts have discovered five defensives paying out bumper dividends that are well covered by earnings and all growing.

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Ian Pierce has no position in any shares mentioned. The Motley Fool UK has recommended Barclays and Lloyds Banking Group. 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.