Is this ‘secret weapon’ a multi-billion pound reason to buy Lloyds shares?

Lloyds (LSE:LLOY) shares have actually performed rather well in recent months. At almost 60p per share, they’re trading at a post-pandemic high.

However, things could get much better for Lloyds in the coming years. Could this post-pandemic high still be a great opportunity to snap up the banking stock?

Let’s take a closer look at why that is.

All about hedging

Hedging is a financial strategy used to mitigate risk. I’ve seen many analogies as to how to best explain the hedging process, but it’s a little like locking in a fixed price on some of your bills to avoid rate shocks.

Banks, like homeowners, look to protect against interest rate fluctuations by creating a portfolio of fixed-interest assets, like bonds. In technical terms, banks often use complex financial instruments like swaps.

Whatever the terminology, it’s all about creating a secure and steady cash flow.

How the hedge will help

Lloyds is no exception. It hedges to manage its exposure to interest rate changes.

This tool, shared by UK domestic banks such as NatWest and Barclays, has depressed profits at these UK-focused banks by 60% in recent years, according to Jonathan Pierce at Deutsche Numis Research.

In other words, if the bank’s net interest margin (NIM) rose at the same pace as central bank rates, Lloyds would be much more — 60% more — profitable. But this isn’t how banks work, and it would expose them to a lot more risk.

As explained above, banks have diverse portfolios of fixed-income assets. Essentially, these are things like old government bonds yielding 1.5% and legacy fixed mortgage rates that are pulling the bank’s NIM downwards as higher interest rates boost variable income.

However, some analysts have termed the structural hedge as a “secret weapon” going forward.

Hedge repricing will significantly boost earnings from here. There are a host of things to consider, including the purchase of higher-yield government bonds and more mortgage customers on higher rates.

Story continues

According to Pierce, hedge repricing could eventually increase profits by 80% at domestic banks.

Lloyds expects average interest-earning assets (AIEAs) to exceed £450bn in 2024, with a NIM over 2.9%. That’s slightly down from 3.11% in 2023.

However, the NIM is expected to stabilise around mid-2024 and expand from there on. In turn, this could lead to a gross hedging income of £5bn or more a year from 2025.

The bottom line on Lloyds

The impact of this hedging is clear from the earnings estimates and the associated forward earnings metrics.

Lloyds is trading at 10.3 times projected earnings for 2024, 8.5 times earnings for 2025, and 7.1 times earnings for 2026. That’s impressive growth.

Of course, it’s not all rosy for Lloyds. It doesn’t have an investment arm and it’s very UK-focused. This means it’s more exposed to the idiosyncratic risks of the UK market.

However, I’d suggest things are looking up for Lloyds. In my view, the potential gains may not be fully priced into the share price.

I already own Lloyds shares, and I’d consider buying more. However, it already represents a considerable proportion of my portfolio so I wouldn’t take a deep dive. It’s important to main a diverse portfolio.

The post Is this ‘secret weapon’ a multi-billion pound reason to buy Lloyds shares? appeared first on The Motley Fool UK.

More reading

James Fox has positions in Barclays Plc and Lloyds Banking Group Plc. The Motley Fool UK has recommended Barclays Plc and 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.

Motley Fool UK 2024