Domestically focused UK bank shares in Lloyds, NatWest and Barclays have made significant gains versus the UK’s premier benchmark, with average gains of around 50% over the past year, meanwhile the FTSE 100 is up 20%.
Some of the recent performance strength is related to fears that interest rates might need to stay higher for longer to tackle inflationary pressures coming from the conflict in the Middle East.
Prior to the US-Iran attack on Israel, economists had been forecasting interest rate cuts from the Bank of England this year, but the ongoing energy crisis as a result of the war has caused a change of expected plans.
Banks tend to benefit from a widening spread between the rate they receive on making loans and the rate they pay to depositors.
Investor sentiment also got a slight boost on relief that the redress outlined by the financial regulator in relation to the car finance commission scandal was lower than previously feared.
Honey, I shrunk the dividend yields
However, if we take a slightly longer perspective, banks’ shares have done exceptionally well on a total return basis (price gain plus dividends).
Looking back over the past three years, Lloyds has delivered shareholders a total return of 189% with NatWest at 223% and Barclays at 268%, according to Sharescope data.
While a lot of the gains have been fuelled by a strong earnings recovery, driven in part by the economic tailwind of higher interest rates, dividend yields have subsequently shrunk considerably.
As the chart shows, before the strong runup in share prices in 2023, NatWest was on a dividend yield of over 8% while Lloyds and Barclays’ were both around 6%.
By comparison, the FTSE 100 was offering a yield of around 4%.
The latest figures show FTSE’s yield has dropped to around 3% while the premium dividend yields offered by the banks have almost disappeared, with Barclays offering a dividend yield of 1.7% or around half that of the FTSE 100.
Everything being equal, a lower dividend yield implies a lower return.
As a simple example, let’s say Alice buys a share with a dividend yield of 8% and the earnings grow 5% a year over the next decade.
In theory, assuming the price to earnings ratio remains the same, the total annual return can be estimated by multiplying the yield by earnings growth, but we can approximate the calculation by adding them together, which equals 13% (8% plus 5%).
If Alice bought the same share with a dividend yield of 4%, (the shares are 50% higher) the total return is 4%, plus 5% or 9%, around a third lower.
From discount to premium to book value
Analysts often compare banks by looking at price to book values and returns on tangible equity. Book value, or shareholders equity, is the theoretical value of a firm, calculated as total assets minus total liabilities.
Because a bank’s balance sheet is comprised mainly of financial instruments, book value is a reliable guide to a company’s true underlying value. Divide book value by shares outstanding gives book value per share.
Return on tangible (excluding non-cash items) equity shows how efficiently a company uses shareholder equity to generate a profit. As a rule of thumb, a 15% return on tangible equity justifies a price to book ratio of 1.5 times.
While UK banks traded at wide discounts to tangible book values three years ago, today they trade at premiums.
Dividend yields have fallen and prices to tangible book values have moved to a premium, suggesting investors have priced in a recovery in bank profitability.
How sustainable are banks’ earnings?
Banks try to smooth earnings across interest rate cycles by putting on structural interest rate hedges, typically on a five-year rolling basis.
Because these were mostly put on in 2020 to 2021 at very low yields and are rolling into much higher current yields, banks are experiencing an earnings tailwind.
Here’s Berenberg analyst Michael Christodoulou: “The structural hedge contribution provides earnings visibility as maturing hedges are reinvested at current rates.”
“Even as the UK economy navigates a ‘tough patch’ — with growth slowing to 0.8% this year and inflation elevated — banks look well positioned to weather the near-term downturn thanks to solid balance sheets and low private-sector debt levels,” explained Christodoulou.
In addition to paying dividends, UK banks have been engaging in share buybacks to return capital to shareholders.
Lloyds is in the middle of a £1.75 billion share buyback, and NatWest is returning £750 million while Barclays has already deployed a £1.5 billion program in 2026 as part of its commitment to return more than £15 billion to shareholders between 2026 and 2028.
The July Financial Stability report from the Bank of England set out plans to ease how much capital banks need to hold to mitigate against shocks. Analysts at Morgan Stanley said the reforms give UK banks more room to use their balance sheets.
Martin Gamble: Shares and Markets Writer
Martin Gamble is Shares and Markets writer at AJ Bell. He was previously the Education Editor of Shares Magazine. He has been with the business since 2019.
Martin graduated from the University of Kent in...
