Lloyds (LSE:LLOY) shares peaked around 54p in February before the US banking crisis brought the global financial stocks crashing down.
However, the selloff has continued for British banks, notably Lloyds, as UK interest rates keep creeping up. So with Lloyds shares currently trading for 43p, surely this is a buying opportunity?
Short-term concerns
While there are obvious positives for banks when interest rates rise, the current high rates will put pressure on Lloyds and its peers. Here’s why:
- Higher interest rates increase the likelihood of customers and businesses defaulting on their loans. This leads to higher impairment costs. In the first quarter, impairment costs came in at £200m — less than expected.
- Banks themselves need to borrow money for their operations, and higher interest rates will increase their borrowing costs.
- Loan demand falls when interest rates increase as people defer purchasing decisions.
- Rising interest rates can negatively impact the value of fixed-income securities in a bank’s investment portfolio.
- Higher interest rates also increase the chances of a hard landing for the UK economy. Banks are cyclical and generally reflect the health of the economy.
With central bank interest rates potentially getting as high as 7% this year, the worry is that the worst is still to come.
Tailwinds remain
Although the even higher interest rates we’re experiencing today clearly have negative implications, tailwinds remain. Here’s what that means for banks:
- Banks generate a significant portion of their revenue from the interest earned on loans and other interest-bearing assets. When interest rates rise, Lloyds can charge borrowers higher rates, resulting in higher net interest margin.
- With savings rates higher than they’ve been for decades, it’s easier for Lloyds to attract new savers and encourage existing savers to deposit more.
- Lloyds will also be making more interest on its deposits with the Bank of England. In 2022, it was suggested that every 25 point basis hike would be worth £200m in revenue.
Investing for the long run
There are certainly some concerns about the bank’s performance over the next six to nine months. And this is reflected in the share price. Lloyds is currently trading at just six times earnings and the dividend yield has pushed up to 5.5% — with coverage of 3.25 times.
However, the medium term forecast is much more positive. Eventually, we can expect the UK economy to return to slow and steady growth while inflation falls, allowing interest rates to hit a sweet spot around 2-3%. This is why discounted cash flow calculations suggest the bank could be undervalued by as much as 50%.
Despite near-term concerns, the low price-to-earnings coupled with better prospects in the medium term, has triggered my interest. Personally, I’ve been buying more Lloyds shares with the price dipping.
It’s nearly impossible to find the nadir but, as a long-run investor, I see this as a great opportunity.
