Lloyds and Barclays most preferred as UK banks 'still offer upside' and returns

Jefferies maintains a constructive, albeit less compelling, outlook on the UK banking sector, noting a 140% total shareholder return since early 2024 and an implied cost of equity now below 14%. The broker favors Lloyds Banking Group and Barclays over NatWest, primarily due to their longer hedge maturities providing tailwinds until 2029, contrasting with NatWest's potential hedge income decline from 2028. While the operating environment remains favorable, concerns persist regarding the UK fiscal position and potential rate disruptions. Jefferies projects significant distributions exceeding £17 billion for Lloyds and strong book value growth for Barclays, reinforcing 'buy' ratings for both.

Analysis

Despite a significant 140% total shareholder return in the UK banking sector since the start of 2024, an analysis by Jefferies suggests further, albeit more moderate, upside remains. The investment case is now viewed as 'less compelling' as the implied cost of equity has fallen below 14%, down from a 15-20% range previously. The operating environment remains supportive, characterized by approximately 4% growth in both loans and deposits, a yield curve that benefits deposit margins, and a £100 billion Bank of England funding program that helps contain costs. However, key risks persist, namely the UK's fiscal position, which could lead to higher bank taxes, and a potential reassessment of interest rates, which is cited as the greatest concern to the capital distribution story. A critical differentiator among the major banks is the timing of 'hedge sunsets'. Jefferies favors Lloyds and Barclays, projecting their hedge-related income tailwinds to last until 2029, whereas NatWest is expected to face a decline in hedge income from 2028 as its shorter-dated positions mature. Consequently, NatWest's valuation at 1.5x 2025 tangible net asset value is seen as less attractive. For Lloyds, Jefferies forecasts over £17 billion in capital distributions between 2025-2027, 20% above consensus, and benefits from Basel 3.1 rule changes. For Barclays, a dividend of around 20p is considered possible with forward book value nearing 500p by late 2026.

Key Decisions for Investors

• Investors with a bullish outlook on the UK banking sector should consider favoring Lloyds and Barclays over NatWest, based on their superior capital return forecasts and longer-duration interest rate hedge profiles which provide income visibility until 2029.
• Holders of NatWest should scrutinize its premium valuation of 1.5x 2025 tangible net asset value in light of the impending 'hedge sunset,' which is expected to create earnings headwinds from 2028 onwards.
• It is critical to monitor UK fiscal policy for any signs of increased bank taxation and shifts in Bank of England interest rate policy, as a marked change in rates is identified as the primary risk to the sector's capital return narrative.
• For exposure to smaller lenders, a relative value assessment suggests OSB Group may offer more upside than Paragon Banking Group, as Paragon's stronger growth metrics appear to be fully priced in at a significant valuation premium.