Lloyds Bank and BT shares: buy or sell?

Two of the UK's most-popular stocks are tipped for contrasting fortunes after a City bank analysed how higher interest rate might impact these FTSE 100 big-hitters.

With speculation that interest rates are bound to rise sooner than expected, a top City bank has had a look at how higher borrowing costs could affect Lloyds Banking Group (LSE:LLOY) and BT Group (LSE:BT.A).

The separate reports from UBS, which have been published ahead of quarterly results over the next month, feature a “buy” recommendation for Lloyds but a “sell” and 130p target price for BT.

The telco's shares today fell another 2.75p to 142.5p as they continue to unwind June's 200p high seen after the Altice business controlled by billionaire Patrick Drahi took a 12.1% stake.

Lloyds shares were today at 48.4p, having rallied 14% in less than a month on hopes for a decent uptick in net interest income as UK interest rates start to rise.

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UBS's Jason Napier thinks the market still under-appreciates the potential benefits as his note highlights a price target of 55p, which would take Lloyds back to its pre-pandemic level and compares with a low point of below 25p just over a year ago.

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He describes Lloyds as “attractively valued” at 7.3 times 2022 earnings per share, representing a 23% discount to the European average.

Lloyds posts its third-quarter results on 28 October, but investors may have to wait until the full-year results in early 2022 to hear more about group strategy and capital pay-out policy under new chief executive Charlie Nunn.

For now, Napier said Lloyds offered market-driven growth as well as the benefits of strong loan loss reserves and decent levels of excess capital.

UK swap rates, the forward contracts used for pricing mortgages, now imply 64 basis points of hikes in interest rates over the next year. But investors are wary that increased living costs could deliver slower economic growth and mean either higher defaults or fewer rate rises than markets currently suggest.

While conceding that there are some risks to consumption, Napier believes that high recent household savings rates during lockdowns provide some buffer and that loan losses are likely to be significantly below consensus forecasts.

He notes that credit card balances are well down, car loans better collateralised due to higher showroom prices and that mortgages are stressed for exposure to interest rates of 5-6%.

Mortgage spreads are narrowing but UBS thinks that the market is discounting the benefit to net interest income growth of steeper swap rates and unsecured volume growth.

Napier, who recently upgraded HSBC (LSE:HSBA)to a “buy” recommendation, said: “We expect UK domestic banks to deliver decent net interest income growth which does not appear factored into estimates or valuations, in our view. We expect a real focus on this at 3Q results.”

The view of UBS on BT is much more pessimistic ahead of the telecoms company reporting second quarter results on 4 November. Analyst Polo Tang's anti-consensus “sell” rating is based on rising infrastructure competition for the Openreach division.

He also doubts whether the upward trend for gilt yields will be as supportive for BT's share price as many assume. There's been a relatively close correlation between the two in the past three years, but going forward the company's actuarial pension deficit is likely to be less sensitive to gilt yields due to other moving parts in calculations.

Every 110 basis point increase in gilt yields is now only a £200 million reduction in the actuarial deficit, whereas every 0.7% increase in the rate of inflation is a £1.6 billion rise in the deficit.

UBS expects BT to report weakening financials quarter-on-quarter and mixed operational trends in the Q2 results, leading to a consensus forecast showing earnings 3% lower.

There might be an update on BT's previously announced suggestion to consider a full-fibre joint venture allowing Openreach to connect up to five million more homes. The division is currently working on its own plan to spend £15 billion on upgrading 25 million homes and businesses from copper phone networks.

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A fibre joint venture could reduce near-term capital expenditure and give a read across valuation to Openreach, but Tang notes that similar deals in the past involving European operators have not led to re-ratings for their share prices.

There's also the danger that co-investment between Openreach and an existing communications provider could be complicated by regulatory concerns. Meanwhile, Sky is said to be exploring a deal to co-invest in Virgin Media O2's full-fibre broadband roll-out plan, speculation that sent BT shares down by 7% at one point last week.

The other consideration in today's note is whether BT could be the target of a takeover approach. Altice acquired its stake on 10 June and is bound by takeover rules not to make an offer until 10 December, but Tang think the complexity of the pension scheme and a potential government veto makes a full takeover approach much less likely.