Passive income is a key objective for many investors. Me included. I prefer to invest in great companies offering strong dividends rather growth stocks.
So today, I’m looking at the banking sector and explaining why I think big banks represent a great buy right now.
Let’s take a closer look.
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Stock market correction
Over the past month, we’ve seen stocks tank. It was largely caused by the collapse of Silicon Valley Bank. The biggest knock-on casualties were other banks as investors started to worry they were sitting on unrealised bond losses.
So with this sector tanking, I’ve been taking a closer look. For me, the selloff in banking stocks has been hugely overdone. Specifically, the concern around unrealised bond losses.
SVB was unique in that it needed to sure up finances by selling bonds at a loss. These bond had gone down in value as prices and yields are inversely related — interest rates have pushed up over the last two years.
It also served a more risky market than most other banks — SVB financed the tech world. It wasn’t a diverse deposit base.
But banks like HSBC, Lloyds and Barclays serve diverse sectors. They have broader depositor bases and more diverse bond holdings. Moreover, unrealised bond losses are less of an issue here as the majority of bonds will be held until maturity.
Furthermore, banks are heavily scruntised these days and are in a more secure position than during the financial crisis. For example, in the European Union, only 2% of debt is considered bad debt. The figure has fallen from €1tn eight years ago to below €350bn last year.
Risks and tailwinds
Of course, the banking sector isn’t risk-free. Recession risks are rising in the US and higher interest rates also contribute to bad debt levels. More bad debt means higher impairment costs. So there are challenges out there for banks.
However, there are several reasons why I’m buying banking stocks now. Firstly, higher interest rates mean higher net interest margins (NIMs). These margins contribute to higher net interest income (NII).
While interest income is high now, banks have a natural sweet spot for central rates, around 2-3% — at this level there would be less concern about debt turning bad.
Thankfully, the medium-term forecast sees rates return to these levels — far above the near-zero rates of the last decade, but below the concerningly high levels we have today.
With higher rates, UK banks are even earning more interest on the money they leave with the Bank of England. For example, Lloyds could be pulling in around £2.5bn in revenue from its eligible assets and held as central bank reserves.
So amid this correction, I’m taking the opportunity to buy more banking stocks. My favourites included hard-hit Barclays and HSBC. The former is currently trading with a price-to-earnings ratio of just 4.6.
Dividend yields have pushed upwards along with this. Barclays offers a dividend yield of 5.3%, HSBC 5% and Lloyds 5.2%. Buying these stocks now can supercharge my passive income generation moving forward. After all, the yield I receive is always relevant to the price I pay for the stock.
