Is this 'secret weapon' a multi-billion pound reason to buy Lloyds shares?

Lloyds (LSE:LLOY) shares have performed very well in recent months. At around 60p per share, they traded quickly after the pandemic.

However, things could get much better for Lloyds in the coming years. Could this post-pandemic boom still be a good opportunity for bank stocks?

Let's take a closer look at why that is.

It's all about hedging

Hedging is a financial strategy used to reduce risk. I've seen many examples of how to best explain the hedging process, but it's like locking in a fixed price on some of your loans to avoid rate shocks.

Banks, like homeowners, look to hedge against interest rate fluctuations by creating a portfolio of fixed-interest assets, such as bonds. In technical terms, banks often use complex financial instruments such as swaps.

Whatever the name, it's all about creating safe and steady cash flow.

How will the fence help

Lloyds is no different. It hedges to manage its exposure to interest rate changes.

This tool, shared UK domestic banks like NatWest again Barclayshas depressed profits at these UK-focused banks by 60% in recent years, according to Jonathan Pierce at Deutsche Numis Research.

In other words, if the bank's net interest margin (NIM) rises at the same pace as central bank rates, Lloyds will be much higher – more than 60% – profitable. But this is not the way banks work, and it will put them at great risk.

As explained above, banks have diversified portfolios of fixed income assets. Essentially, these are things like old government bonds yielding 1.5% and legacy mortgage rates that drag down a bank's NIM as higher interest rates increase variable income.

However, some commentators have called the building fence “secret weapon” move forward.

Hedge price reductions will significantly improve revenue from here. There are many factors to consider, including the purchase of high-yield government bonds and mortgage customers at high rates.

According to Pierce, hedge sales can end up increasing profits by 80% for domestic banks.

Lloyds expects average earned income assets (AIEAs) to exceed £450bn by 2024, with a NIM of over 2.9%. That's down slightly from 3.11% in 2023.

However, NIM is expected to stabilize by mid-2024 and expand from there onwards. In turn, this could lead to hedge funds of £5bn or more a year from 2025.

Priority for Lloyds

The impact of this restriction is evident in the income estimates and related profit metrics.

Lloyds trades at 10.3 times 2024 forecast earnings, 8.5 times 2025 earnings, and 7.1 times 2026 earnings. That's an impressive growth.

Of course, all is not well for Lloyds. It does not have an investment arm and is mainly focused on the UK. This means that it is highly exposed to the unusual risks of the UK market.

However, I would suggest that things look up for Lloyds. In my opinion, the potential benefits may not be fully factored into the share price.

I already own Lloyds shares, and would consider buying more. However, it already represents a large part of my portfolio so I won't take too deep. It is important to maintain a diversified portfolio.