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I’m buying Lloyds shares for the juicy 6.25% forward yield!

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Lloyds (LSE:LLOY) shares aren’t always the most exciting on the FTSE 100. It’s a British bank with a low appetite for risk. In fact, Sir Antonio Horta-Osorio was knighted for his efforts in making the institution more stable and lowering its exposure to risky operations.

So why am I buying more Lloyds shares? Let’s take a closer look.

Improving yield

Currently, Lloyds offers a dividend yield around 4.2%. That’s above the index average, and I’m quite content with it.

However, City analysts are forecasting a full-year dividend of 2.4p in 2022, rising to 2.7p and 3p in 2023 and 2024 respectively. The 2024 figure represents a 25% increase from the current position. 

This would mean the forward dividend yield for 2024 would amount to 6.25%. For me, that’s very attractive, especially from a company will a relatively low risk profile.

These inflated dividend payments would likely be easily affordable. The dividend coverage ratio in 2021 was 3.8. That means earnings could cover stated dividends 3.8 times. Normally, a yield above two is considered healthy.

Interest rate sensitivity

Lloyds doesn’t have an investment arm and because of its funding composition, it has higher interest rate sensitivity than other banks.

That hasn’t been ideal over the past decade, as rates have been near zero. But now rates are rising and net interest margins (NIMs) are growing. The bank said the NIM was forecast to reach 2.9% by the end of 2022, and it could grow further in 2023.

Moreover, this could be a tailwind that lasts for some time. After all, mortgages are often fixed and customers taking mortgages now will be stuck on higher rates for longer. Hedging strategies can also help extend these gains.

Around 70% of the bank’s income come from UK mortgages. As such, changes to the NIM have a disproportionately large impact on revenue generation. In some respects, this dependency on UK mortgages isn’t ideal. But, traditionally, it’s been a fair steady area of the market.

It’s also worth noting that Lloyds is even earning more interest on its deposits with the central bank. Analysts suggest that every 25 basis point hike is worth £200m in interest revenue.

Discounted share price

Lloyds has been trading at a discount for some time. In fact, some discounted cash flow models suggest the stock could be undervalued by as much as 55%. But, of course, the model is dependent upon forecast cash flow, and this can be challenging to predict.

The discount could, and probably does, reflect concerns about the UK economy in the near term. The nation has staved off recession at this time, but the forecast for 2023 is pretty flat. Many analysts still anticipate a recession.

Banks feel recessions particularly badly. When the economy goes into reverse, move debt turns bad. And banks have to respond by putting more money aside. In Q3, impairment charges soared to £668m from a release of £119m a year before as bad debt concerns increased.

Hopefully, not all that money will be needed. And it’s not that I’m discounting the impact of bad debt, but I believe higher interest rates will drive greater returns in the coming years.

The post I’m buying Lloyds shares for the juicy 6.25% forward yield! appeared first on The Motley Fool UK.

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