Lloyds (LSE:LLOY) shares were among the least impacted by the stock market correction that primarily hit banks in recent weeks. The lender is down 10% over a month, and is pretty much flat over the year.
But after the drop, we’re now seeing Lloyds trading at just 6.5 times earnings. That’s makes it one of the cheapest UK banks. It also means it’s around half as expensive as the FTSE 100 average using the price-to-earnings metric.
I’ve been topping up on Lloyds shares as the price fell. Here’s why.
Interest rates
Interest rates are key to banks. In fact, Lloyds, because of its funding composition and lack of an investment arm, is even more sensitive to interest rates changes than other banks.
The thing is, higher interest rates are good for such businesses in general, but can eventually work against them. And right now, interest rates have probably moved too high in the UK. At higher rates, we see more debt turn bad and impairment charges increase.
However, we’re nearing the likely highest rate, and most analysts expect interests rates to start moving downwards in the second half of the year. The medium-term forecast sees rates sitting somewhere between 2% and 3% — that would be ideal for banks.
And analysts are fairly confident that the base rate will stop well short of 5%. There are several reasons for this, but among them is the notion that the UK economy probably isn’t strong enough to absorb even higher rates.
The tailwind
It’s important to understand how big the tailwind is from higher interest rates.
Lloyds’s net interest margin — the difference between lending and savings rates — rose 40 basis points to 2.94% in 2022. Lloyds is targeting more than 3.05% in 2023, but some analysts have suggested this is quite conservative.
It’s also important to note that banks earn interest on central bank deposits. Some analysts suggested Lloyds could be earnings around £3bn a year in extra revenue from its billions held as central bank reserves.
But once again, it has to be recognised that impairment charges rise when interest rates are as high as they are now. Some dovish policy could be useful going forward.
This is a vastly different set of circumstances versus the near-zero rates of the last decade.
Should I worry about bond losses?
So should bond losses be a concern for me? In my opinion, no. Liquidity is strong, and there’s no need to sell bonds at a loss. Instead, Lloyds will hold these bonds through to maturity.
It has been keeping healthy liquidity buffers, which are well ahead of regulatory requirements. The bank reported liquidity coverage ratio (LCRs) of 144% at the end of 2022. This put it ahead of most major European and US banks — only four banks have LCRs above 150%.
The liquidity ratio shows how much strain a bank can withstand in the short term. The higher the measure, the stronger the institution.
Because of the above, I see Lloyds as a strong, stable, and well-priced stock for my portfolio.
