The Bank of England (BoE) recently raised interest rates to 3%. This should be positive for bank shares such as Lloyds (LSE: LLOY), but its stock is down 8% this year. With that in mind, I’m deciding whether to buy Lloyds shares.
High street banks tend to fare better during periods of elevated interest rates. This is primarily because the interest they charge customers for borrowing money is much higher than the interest they have to pay into customers’ savings accounts. This is otherwise known as net interest income (NII).
In its Q3 update, like other banks, Lloyds’ NII continued to impress. Despite that, the FTSE 100 firm has had to set an increasing amount of money aside to cover the rising level of bad debts (impairments). Therefore, its profit after tax actually took a substantial hit, cancelling out any benefit from the improved NII.
Underlying net interest income
Underlying profit (pre-impairment)
Statutory profit after tax
Nevertheless, inflation continues to rear its ugly head and the Bank of England is expected to continue raising interest rates. Consequently, Lloyds updated its 2022 guidance and now expects higher net interest margins, although profits are still likely to take a hit from higher impairment charges.
So, why is the bank expecting higher impairment charges? Quite simply, this can be attributed to customers’ inability to repay their loans. Given that Lloyds is the country’s biggest mortgage lender, having the average mortgage rate sitting at a 13-year high of 5.42% isn’t going to help the two million people on variable rate mortgages. To make matters worse, another two million people on fixed rate loans will face higher payments when their deals expire soon.
Additionally, upon looking at the black horse bank’s financials, the number of late-stage loans are starting to rack up. Loans that are considered to have a high risk of defaulting have increased by 25% since the last quarter. Pair this with a slowing housing market and it means fewer and smaller mortgages may be taken out, which could impact Lloyds’ revenue in the medium term.
Solid balance sheet
That being said, the company still has a strong balance sheet. The firm has a CET1 capital ratio of 15%, which remains above its ongoing target of 12.5%. This is essentially the amount of liquidity a bank possess to cover its risky assets.
Will I buy Lloyds shares on that basis? Well, despite the headwinds, there are also tailwinds. Aside from the wider margins, CEO Charlie Nunn mentioned that management remains committed to looking at returning excess capital at the end of the year. Brokers from Barclays, JP Morgan, and Deutsche also believe that there’s still quite some upside potential to be achieved. Moreover, the recent autumn statement provides some relief regarding a lower-than-expected tax rate for banks and the elimination of speculation surrounding a windfall tax.
Nonetheless, it’s worth noting that brokers have since brought their target prices down to an average of 59p. This still brings a 37% upside to Lloyds’ current share price. However, I believe the risks remain large as impairment charges rise rapidly and mortgages become increasingly unaffordable for some. As such, I’ve since sold my positions because I believe that there are better stocks with lower risk and better potential to invest in for the long term.
JPMorgan Chase is an advertising partner of The Ascent, a Motley Fool company. John Choong has no position in any of the 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.
Motley Fool UK 2022