UK Banks Return to Favor in Turnaround Year

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After five long years of deleveraging, the U.K. banking sector finally looks ready to make a comeback, with 2013 set to be a turnaround year, analysts have told CNBC.

Major U.K. banks are finally at a stage where they can start growing their books again, and some of the most maligned FTSE stocks have started to come back into favor with income fund managers.

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Thomas Moore of Standard Life, who runs an income portfolio, said he is very supportive of the sector and the valuations are compelling.

"I don't think investors have quite worked through in their minds U.K. banks will become some of the highest yielders in the market and they are not being priced accordingly, "said Moore.

"Signs of an improvement in the housing market in the U.K, led initially by London and South East are spreading out to the wider economy. Although house builders are the most direct way to be able to access that, the banks are beneficiaries because they are finding their mortgage volumes are starting to improve," said Moore.

Barclays, which received cash injections totaling 6.1 billion pounds from Middle Eastern investors rather than a government bailout, is Moore's pick of the banks.

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"We have a significant holding in Barclays and have been adding to it. Barclays isn't a traditional stock in an income fund because investors have underestimated the dividend paying ability of the bank," he added.

Chirantan Barua, senior U.K. bank research analyst at Bernstein Research is also bullish on U.K. banks for the first time in years.

"We are bullish on U.K. retail banking. After years of muted growth driven both by supply side and demand side factors, we believe 2013 will be a turnaround year," he said.

"A combination of mortgage and unsecured loan growth coupled with improved profitability from better mortgage economics and lower impairments bode well for U.K. retail banking in 2013," he added.

Lloyds stands to benefit the most from the recovery of the U.K. consumer, followed by fellow taxpayer bail-out Royal Bank of Scotland, Barclays and HSBC said Barua.

Cazenove Capital's Matt Hudson is also backing the banks and his top stock picks of the year are Barclays, HSBC and Lloyds.

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Barclays' share price has recovered from the LIBOR scandal last year, but is still attractive he said.

"The strategic review was taken well by the market, but it is still on an attractive discount to other EU banks, and you have to think this discount will erode over time."

However, Martin Cholwill of Royal London Asset Management is more cautious and only holds HSBC at the moment , doubling his position in the stock to just over 5 percent since the start of the year.

"I am still of the view that HSBC is an investable bank and RBS, Lloyds and Barclays are stocks to avoid," he said.

He is however positive on the stock market as a whole and predicts there is still more for banking stocks and the market in general this year.

"I think the underlying tone of the stock market remains positive, despite the fact we have had a good year so far. I think we will look back on the year as a whole and see good returns," he added.

By's Jenny Cosgrave; Follow her on Twitter @jenny_cosgrave