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FUND MANAGER VIEW: Why income investors should consider UK banks

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UK banks are gradually returning to health and could prove to be an attractive investment for income seekers.

UK banks have not tended to feature heavily in the minds of UK income investors since the crisis.

Lloyds Banking Group last paid a cash dividend in 2008 prior to its purchase of HBOS – a transaction which further stretched its already weakened balance sheet and contributed towards the eventual part nationalisation of the group by the UK government.

Royal Bank of Scotland suffered a similar story with its ill-fated acquisition of Dutch bank ABN AMRO in 2007. Its eventual rescue by the UK government spelled the end of dividend payments to investors as the bank began a massive restructuring and de-leveraging operation which is ongoing today.

Barclays on the other hand managed to avoid a government bailout, but was not immune to the same financial pressures which beset its peers. Its once attractive dividend payment had to be sacrificed to allow for a strengthening of the balance sheet and it fell from 31 pence per share in 2007 to a meagre 2 pence in 2009.

Fast forward six years and the income opportunities from UK banks look more promising.

Barclays and Lloyds have made material progress in their asset reduction programmes (for example Barclays disposing of their stake in Blackrock and Lloyds selling their Scottish Widows Investment Partnership). With vast improvements in capital positioning and balance sheet strength, both companies seem destined to improve their dividend paying attractions in the short to medium term.

In the case of Barclays, the ability to ramp up dividend payments came slightly sooner. It has paid a dividend yield of over 2% since 2010, however more recently, concerns over its leverage ratio have led to the company announcing an expected dividend payout ratio of 40% which is at the low end of their previously communicated range. Nonetheless, the market still expects a yield of close to 4% in 2014 rising to 5.5% the following year.

2013 saw the UK government begin to sell down its stake in Lloyds, and while it remains significant holders, it is reassuring it has begun its exit, which is likely to pave the way for the company to take more control over the destiny of its own dividend policy. Once again, the most recent guidance has been slightly disappointing versus market expectations, with Lloyds guiding to a 50% payout ratio in the medium term (below the market’s expectation of 60%). However, once again, it is conceivable, given current capital positions, that the company will be able to achieve a dividend yield close to that expected by the market (2.1% in 2014, rising to 4.2% in 2015).

There will surely be further bumps. The imminent asset quality review (AQR) has the potential to complicate matters and demand even more stringent capital strength as the European regulator stress tests the balance sheets of all European banks.

But it is fair to say that both Barclays and Lloyds find themselves in a far more healthy financial condition today than they have been at any point since 2007, and hence from an income investor’s perspective, UK banks can once again be seen flashing on the radar screen.

Thomas Buckingham is portfolio manager of the JPM UK Higher Income fund

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