Banks are back: How the UK's banking sector got its mojo back as dividend payments rise

 
Annabelle Williams
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Banks may have become the City's bad guys - but consensus is divis will rise (Source: Corbis)

The UK’s banks are back on form and could be the best place to invest for good and growing dividends.

British banks such as Lloyds, HSBC and Barclays were once the best places to invest for solid dividends. Ten years ago, banks provided a quarter of all dividends in the UK market, according to figures from OMGI.
But when banks were battered during the financial crisis, not only did their share prices plummet, but many were forced to suspend dividend payments too.
In the six years since the crisis, banks have either been paying out meagre dividends, or nothing at all.
As banks have struggled to recapitalise and have been hit with a number of huge fines, fund managers have turned to supermarkets, insurance companies and the oil giants for dividends.

Dividend slowdown

But now dividend payments across the UK market have begun to stagnate. The bulk of dividends are paid by around 20 big companies – and many of these are facing new problems.

One of the biggest dividend-payers in the market, Tesco, was forced to cancel its payout for 2014-15 after an accounting scandal showed it had a black hole in its finances. This has made a “measurable dent” in the outlook for overall dividend income available to investors, says Capita Dividend Monitors.
Meanwhile, insurance companies have been hit by the government’s changes to pension annuities, and profits at oil and mining companies have suffered in the face of falling commodity prices.
Given these mounting pressures, dividend growth in the UK has been slowing. Last year, growth came in at a measly 1.4 per cent – the lowest rate of expansion since 2010.

Banks back on form

But six years on from the depths of the crisis, UK banks are now returning to form. The health of these businesses is reflected in their dividends, with HSBC and Barclays paying dividends of 50 cents and 6.5p, respectively – although Royal Bank of Scotland is yet to resume dividend payments.
Last month, Lloyds announced its first dividend since the government was forced to bail it out in 2008. Lloyds will return 0.75p per share to each of its 3m shareholders for the 2014 financial year.
The payout may be low, but consensus expectations are for a 3p per share payout at the end of 2015, rising to 4p by the end of 2016, according to Bloomberg.
Lloyds’ chief executive Antonio Horta-Osorio said he hopes that resuming dividend payments will lead to much higher interest in the bank’s shares, which in turn will help it to recover further.
“The management at Lloyds would like it to become a dividend machine,” says Eric Moore, manager of the Miton Income fund.
Many fund managers believe UK banks are back on track, and some have been buying up shares in anticipation of higher dividends in future. Banks will also be beneficiaries of interest rate rises, making them doubly attractive to investors.
Shares in both Lloyds and HSBC have risen 11 per cent over the last six months, although Lloyds’ share price has been weakened by the government selling down its stake.
Stephen Message, manager of the Old Mutual UK Equity Income fund, is holding HSBC as a top-ten position in his fund, and also has stakes in Lloyds and Barclays.
Although he recognises Lloyds’ new 0.75p dividend is small, Message says the move to resume dividend payments is symbolic and indicates there are good times ahead for the bank.
“Lloyds coming back to pay dividends is a key marker for the company. It is a sign management are confident and beginning to look forward rather than backwards,” he says. “A few years ago the prospect of Lloyds paying a dividend would not have even been contemplated.”

Buy and wait

Message says his philosophy is to buy stocks with lower dividend yields in anticipation of higher payouts in future.
“Share prices follow dividends. If you look over the last 40 years, 80 per cent of investment returns on the FTSE 100 have come from the re-investment of dividends,” he explains.
But this does mean investors have to be willing to play a waiting game. “For the broader banking sector it will be two steps forward and one step back, but the broader trend is one where [dividends] can continue to rise.”
Barclays, for example, is currently paying out 30 per cent of its profits in dividends. Message is expecting this figure to rise to 50 per cent in the next three years.
The sheer size of the banks means investors cannot afford to ignore their potential. With its new dividend policy, Lloyds is paying out a total of £500m for 2014, and this figure could soon grow to a sizeable chunk of the total £80bn paid out annually by UK companies.
“While 0.75p seems a small amount on a per-share basis, actually £500m overall is a large chunk of money. Lloyds could maybe pay out 2p, then 3p, and then 4p in dividends, and that would mean them paying £2bn-£3bn worth of dividends,” Message says.
Banks will also be beneficiaries when interest rates rise from their historic lows. While the timescale for rate rises remains uncertain, interest rates are likely to only move upwards.

Look elsewhere

But not all managers are convinced the numbers stack up. Moore says Lloyds’ dividend is simply too low to warrant investment at the moment.
In relation to its share price, a dividend of 0.75p per share gives a dividend yield of less than 1 per cent. “It is less than pulse-quickening for an income investor,” he says.
In recent years, banks have been hit by an unprecedented number of fines for a range of misdemeanours, from PPI mis-selling and Libor rigging, to breaking international sanctions and the manipulation of foreign exchange markets. Figures show banks around the world have paid a total of £166bn in fines over the last six years.
Moore says it is impossible to be certain banks will not face another round of regulatory scrutiny, and a fresh thwack of fines could be just around the corner.
He adds: “The problem is [potentially more] bouts of bad stuff that mean banks’ profits are much lower. Could interest-only mortgages become the next big mis-selling scandal?”
Funds to watch
There are over 70 funds in the UK holding banks among their top-ten investments. Below are four strong funds with a focus on income and high exposure to banks.
F&C RESPONSIBLE UK INCOME FUND
HSBC is the largest investment in this fund, which has 25 per cent of its assets in UK financials. All companies are put through an ethical screening process, and the fund has returned 43 per cent over the last three years.
PREMIER INCOME FUND
This fund has nearly a third of its assets invested in UK financials, with HSBC the largest single holding. The fund has made 46 per cent over the last three years.
JPM UK STRATEGIC EQUITY INCOME FUND
Barclays, Lloyds and HSBC feature among the ten largest positions in this fund, which has a total of 10 per cent invested in UK banks. The fund has returned 41 per cent in three years.
M&G EXTRA INCOME FUND
This fund invests in both equities and bonds, including UK government gilts. The fund has 70 per cent in equities at the moment, including 6 per cent in UK banks. It has made 37 per cent over the last three years.

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