Loan defaults are a key risk for banks, and investors and analysts watch them carefully. One key trend we’ve seen play out over the past year or so is remarkable resilience from borrowers in the face of inflation and higher interest rates.
Banks must account for actual and forecast loan losses in their accounts. Charges taken show up as impairments in the income statement and banks will also report default levels separately.
The positive news from first quarter results was that default levels remained low, and impairment charges came in lower than analysts were expecting across the board.
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Higher rates for longer
Higher interest rates tend to be good for banks, as long as it doesn’t push borrowers into trouble.
With borrowers looking strong, the fact interest rates might stay higher than previously thought could act as a tailwind for several banks – especially when we consider where company guidance sits.
A few of the major banks have guidance that’s built in several rate cuts this year, cuts that no longer look as likely. It’s too early for the banks to change their guidance figures.
But if things stay on the current trend, we could see some guidance raises coming over the next few quarters. Our preferred options for this trend are the UK-focused banks, where default levels look particularly robust. Of course there are no guarantees.
The UK economic outlook is improving
Several banks upgraded their UK economic forecasts, and management teams called out the UK’s strength on investor calls, including some of the more global players.
This is one of the reasons we favour UK-focused banks at the moment. The return of wage growth that outpaces inflation, and an improving housing market, are good indicators for the UK.
We heard from management teams that they expect loan growth in the UK to improve over the course of the year, reflecting the improved outlook. That would be good news for banks and applies to both secured (e.g. mortgages) and unsecured loans.
Capital levels are strong
One of the key factors for this cycle is the banks are sitting on strong capital levels (CET1 ratios).
This is important as capital allows banks to absorb shocks, acts as a foundation for growing the loan book and offers scope for shareholder returns.
As a reference point, the average minimum CET1 ratio used by the Bank of England in their latest stress test was 6.9%. Most banks have an internal target well in excess of that, 13-14% is fairly common.
When we look at the UK listed banks, we think the potential for shareholders returns should be seen as a key attraction.
A good run so far in 2024 means yields have come down a touch. But as well as giving scope for dividends, strong capital positions mean analysts are expecting buybacks on top. Remember, yields are variable and no dividends or shareholder returns are guaranteed.
Investing in an individual company isn’t right for everyone because if that company fails, you could lose your whole investment. If you cannot afford this, investing in a single company might not be right for you. You should make sure you understand the companies you’re investing in and their specific risks. You should also make sure any shares you own are part of a diversified portfolio.
Where do we stand on the sector?
We see value in UK-listed banks, specifically those with a UK focus. Valuations look attractive, and banks are still yet to fully realise the benefits of the higher-rate environment.
Over the coming years, the structural hedge is set to be a powerful tailwind for interest income. The easiest way to picture the hedge is like a bond portfolio. Banks use some of their assets to create a portfolio of bonds and earn a stream of cash flows at a fixed interest rate. As rates in the real world go up and down, the hedge helps limit the impact of rate volatility and smooths earnings.
The best part?
You don’t need to do anything to claim it – other than place a deal.
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This article is original Hargreaves Lansdown content, published by Hargreaves Lansdown. It was correct as at the date of publication, and our views may have changed since then. Unless otherwise stated, estimates, including prospective yields, are a consensus of analyst forecasts provided by Refinitiv. Yields are variable and not guaranteed. Investments rise and fall in value so investors could make a loss.
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