A strong set of half-year results last week gave Lloyds Banking Group (LSE: LLOY) shares a lift. I think further gains are likely as Lloyds benefits from rising interest rates and a strong financial position.
After years of frustration, I reckon this FTSE 100 stock may finally be about to deliver on its potential. If I’m right, then Lloyds shares could be too cheap to ignore right now.
What’s the big deal?
Lloyds generates more than 70% of its turnover from net interest income. That’s the difference between the amount of interest the bank charges borrowers and the interest it pays to savers.
The numbers involved are pretty huge. At the end of June, Lloyds had £456.1bn of outstanding mortgages and loans, and £478.2bn of customer deposits.
Over the last decade, interest rates have been close to zero. This has made it difficult for banks to charge competitive rates on lending, while still paying interest to savers.
Now that interest rates are rising, it’s easier for Lloyds to expand the gap between lending rates and savings rates. In effect, the bank can increase its profit margins.
This is what’s been happening this year. It’s the main reason why Lloyds’ underlying profit rose by 34% to £4.1bn during the first six months of 2022.
Are further gains likely?
The main Bank of England interest rate has already risen from 0.25% to 1.25% his year. The bank’s rate-setting committee is due to meet again on 4 August. I suspect we’ll get another 0.25% increase to try and bring inflation under control.
Even if this doesn’t happen, I think Lloyds is likely to see interest income rise further during the second half of the year. Existing mortgage customers will be rolling off fixed rates onto new higher rates. New borrowers will have no choice but to sign up at higher rates.
One interesting statistic I saw recently came from property website Rightmove. It says that the average mortgage payment for a first-time buyer has risen by 20% so far this year. A lot of that increase is due to rising interest rates.
What could go wrong?
Interest rates are a bank’s main source of profit. But as a potential investor, I need to consider the flipside. What if Lloyds’ customers start missing their mortgage payments or cutting back on credit card usage?
The majority of Lloyds’ lending is to customers with strong credit ratings and stable incomes. So far, chief executive Charlie Nunn says the bank isn’t seeing any serious signs of stress. Bad debt levels are reported to be below pre-Covid levels.
Why I think Lloyds is cheap
If the UK suffers a deep recession, then Lloyds’ lending losses could become more of a problem. However, Lloyds’ finances look very healthy to me. I don’t see much risk to the dividend, which is expected to rise by 16% to 2.3p per share this year. This payout would give Lloyds shares a dividend yield of around 5.3%.
However, if the bank’s profitability continues to improve, I think further dividend increases are likely. That could help push Lloyds’ share price higher. In my view, Lloyds looks good value right now. I’d be happy to buy the shares at current levels.