Can Income Investors Trust UK Banks?

Disruptors like Monzo, Starling and Atom are briskly taking up market share in retail banking, particularly as high street branches close and consumers now expect to do simple transactions on their smartphones.

Two of the high street’s biggest names, Royal Bank of Scotland (RBS) and HSBC (HSBA) are currently without permanent chief executives: RBS has not yet appointed a successor to Ross McEwan, who has been in charge since 2013. And HSBC announced this week that John Flint will be leaving with immediate effect, having been in the role since February 2018.

Still, the UK banks “have been regulated down to being almost being utilities now”, says Merian banking analyst Rob James, who works with fund manager Richard Buxton on the Merian UK Alpha Fund. The UK Alpha fund is rated Silver by Morningstar and has HSBC within its top five holdings.

For investors, there’s the knowledge that the banks are in a stronger financial position now, and with Lloyds and HSBC yielding over 6%, this has tempted income investors back in. These yields are up there with some of the FTSE 100’s biggest income stocks such as BP, British American Tobacco and WPP. Morningstar rates HSBC, Lloyds, RBS and Barclays shares as undervalued, meaning that investor expectations are low, a sentiment that backs up the idea of banks as dull but steady cash-generating machines.

Reliable Dividends?

But in an environment when FTSE 100 firms such as Vodafone are cutting dividends, can UK investors still trust the banks to provide reliable income? Merian’s James thinks that UK banks would want to avoid cutting dividends at all costs, especially with the financial crisis still within investors’ memory.

This is especially the case for RBS, which went a decade without providing any income to investors. James thinks it’s significant that the banks are now relying on special dividends and share buybacks to boost their payouts: for example, RBS is paying a special dividend worth £1.7 billion, £1 billion of which is destined for the Treasury (because of the Government's stake). This means that the ordinary dividend is easier to maintain in times of financial stress. Including the special dividend, this calendar year’s yield would be over 10%, but the ordinary dividend yield is below 3%, which is less vulnerable to a cut, James argues.

Lloyds Resilient, But PPI is a Worry

Morningstar analysts think Lloyds Banking Group possesses an “economic moat”, or competitive advantage, albeit a narrow one, whereas RBS is without this. Brands such as Lloyds Bank, Scottish Widows and Halifax provide a “robust UK retail franchise”, analysts say.

Analysts believe that, even though the bank is highly exposed to the UK economy, it will weather any short-term volatility following Brexit. The share price tells a different story, however - one that fully reflects most of the worst-case scenarios imagined by investors. Before the Brexit vote in 2016, Lloyds shares were trading above 80p are now around 50p. Morningstar analyst Niklas Jammer assigns a fair value estimate of 76p to Lloyds Banking Group shares.

Brewin Dolphin’s senior investment manager Donald Brown argues that Lloyds’ simplicity could prove highly advantageous in the months ahead: “Brexit remains a challenge for the entire banking industry, particularly domestically-focused banks, but Lloyds appears well placed to weather the storm.”

One area of concern remaining is compensation for payment protection insurance (PPI). While the first fine for PPI mis-selling was imposed by the then FSA back in 2006, the deadline for claims is the end of August 2019. Banks’ exposure to PPI claims has been a long-running hit to profits and has harmed investor confidence in the sector. Lloyds’ claims hit £550 million in the second quarter of this year, against £450 million in the same quarter last year. Morningstar analysts say that final figure for claims are difficult to pin down, especially with a rush expected as the deadline approaches.

Barlcays and HSBC Better Diversified

Barclays (BARC), like RBS, has no economic moat, according to Morningstar analysts, but is rated as a four-star stock with a fair value estimate of 220p, above the current price of 150p.

In its most recent results, cost-cutting remained a strong theme and the numbers told a similar story to that of the other banks: high street retail banking is a difficult market, with a mortgage price war hitting profits for the main providers. The contribution from Barclaycard in the reporting period was also lower than the same time last year, although Barclaycard remains the market leader among UK credit cards, with more than a 25% market share.

Morningstar analyst Niklas Kammer says the results were flattered by comparisons with last year, when costly litigation and hefty fines for misconduct hit profits. After these costs are stripped out, profits were down around 15%. Still, he maintains his 220p per share fair value, above the current price of around 150p. Barclays is less dependent on the UK economy than Lloyds and RBS, it has valuable overseas earnings. Its yield of 4.4% is not in the league of HSBC or Lloyds but it is similar to other FTSE firms such as Glaxo and BAE Systems.

HSBC is rated as by Morningstar as a four-star stock with a fair value estimate of 800p, against a current price of 637p. Morningstar analyst Michael Wu thinks the departure of John Flint after just 16 months in the job is “surprising”: “While the bank continues to execute its strategy of lowering costs and said there was no disagreement about strategy with Flint, it appears the pace and magnitude of change currently set out was not sufficient for the board.”

The sudden departure of the boss weighed on shares initially, but HSBC is regarded as better diversified internationally than Lloyds and RBS. As one of the biggest companies in the FTSE 100, it is better capitalised than the other three high street banks. A stalwart of many income portfolios, a dividend cut from HSBC would cause a minor uproar among retail investors and pension funds. Like Lloyds, the bank last cut in 2009 and has been increasing shareholder returns through share buybacks rather than boosting payouts beyond the standard interim dividend of 10 cents per share.

Stress Tested

Merian’s Rob James says the key point about the UK banks is that they have passed the Bank of England’s stringent annual stress tests and are now among the best capitalised in Europe. Even with the extreme scenarios of the stress tests - which simulate a plunge in house prices and sterling as well as an economic crash - the banks still have enough capital to keep functioning.

Still, there are risks to investors in the sector, especially if Brexit triggers a prolonged economic slowdown. “Long-drawn out slumps are very painful for bank equity investors,” he says.

Morningstar's Niklas Kammer thinks that while the banks would be resilient in the face of a Brexit-inspired economic downturn, they could face restrictions on dividends until their capital buffers are restored to levels that regulators are comfortable with. Even though a hard Brexit is not the most likely scenario he says: "Given the unprecedented case of Brexit we would therefore not consider UK banks’ dividends as fail proof."

So what should investors expect of the sector in the near future? Brexit is likely to weigh on valuations and keep share prices subdued, but dividends should be well protected except in the event of severe economic crash.