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BRADFORD & BINGLEY (BB.)

Created:

29 June 2007

Updated:

14 April 2008

Written by:

John Adams

Admittedly, last week's trading update from mortgage lender Bradford & Bingley (B&B) contained plenty of good news. Management said that new lending for house buying in the first half of this year will be almost double the growth achieved in the previous first half, while the bad debt charge is likely to be in line with the modest levels experienced in 2006's first half. But the update also carried signs that the bank's longer-term future may be less bright.

Much of that reflects the impact of rising interest rates in the UK. After four rate hikes since last August, interest rates now stand at 5.5 per cent and more rate rises are widely anticipated. But rising rates hit demand for credit and can trigger more bad debts as borrowers struggle to repay loans. Indeed, B&B's update acknowledged the beginnings of just such an effect, pointing to a slowing rate of growth in the housing and mortgage markets.

And with 58 per cent of its loans in buy-to-let mortgages, B&B looks more exposed to an especially vulnerable part of the housing market than many of its competitors. "Buy-to-let is a negative carry trade (the cost of financing a house purchase is not covered by rents) that only makes sense with strong house price inflation," says the banking team at stockbroker Numis Securities. "Should the market turn flat, it would be logical for landlords to sell." So, if buy-to-let borrowers do begin selling-up, then that could spell bad news for B&B's interest income. By contrast, mortgage lenders with conventional owner-occupier loans should avoid a chunky slide in income.

The outlook for the group’s net interest margin (the difference between its cost of funding and its loan rates), which was a fairly thin 1.2 per cent in 2006, doesn't look great, either. The bank's trading update noted that there had been a "modest dilution" in this margin during the first half of 2007. Management blames the funding mix - ie, the cost of funds. Some banking analysts are, however, doubtful about that. "Normally, such costs would be passed onto the customer," says banking analyst Alex Potter, of stockbroker Collins Stewart. "We believe rising competition to be the reason this has not happened." B&B certainly faces tough competition from other lenders with a presence in this market, such as Alliance & Leicester.

Nor should B&B's shareholders bet on a takeover bid rescuing their investment. True, bid rumours have followed B&B ever since it demutualised in 2000, with such lenders as Barclays and Spain's Banco Santander touted as potential suitors. But those rumours have gone cold in the past year or so.

That said, with a prospective dividend yield of over 5 per cent, B&B's shares remain attractive for income seekers. There is good news on costs, too. The bank's underlying cost-to-income ratio fell 1.4 percentage points during 2006 to an efficient 44.2 per cent. Management also said that the pace of rising costs remains below the rate of revenue growth, suggesting that a further improvement in this ratio is on the way.

Even so, the shares are no bargain. Northern Rock's shares, for example, are rated in line with B&B's, but Northern boasts higher growth and a more efficient structure, leaving it better placed to cope with tougher market conditions. Add that to the weak bid prospects, and the fear that B&B's focus on buy-to-let lending leaves it at the riskier end of the mortgage market, and the shares look expensive. Sell.

BEAR POINTS

Buy-to-let market vulnerable

Weakening lending margins

Bid rumours have gone stale

Shares trade in line with better placed rivals'

BULL POINTS

Decent dividend yield

Cost-to-income ratio continues to improve

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