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Economic and Market Commentary

Australian Bank Hybrids: Navigating the Transition to Alternative Income Sources

Robert Mead, Adam Bowe, Fabian Dienemann
The hybrid phase-out opens the door to optimised global fixed income portfolios offering competitive returns with lower risk.

Key takeaways

  • Expanding beyond domestic hybrids to a global fixed income opportunity set can unlock better returns and greater diversification.
  • To match the expected return from hybrids, only 25% of existing hybrid exposures need to be allocated to illiquid strategies such as private credit, with the balance invested in daily liquid bond solutions.
  • A diversified approach that incorporates interest rate, yield curve, and securitised credit risks—rather than focusing solely on corporate credit—can offer a superior risk-return profile compared with Australian hybrids.

Australian bank hybrids, also known as Additional Tier 1 (AT1) capital, have long been a staple in the portfolios of Australian investors. However, the Australian Prudential Regulation Authority (APRA) announced in December 2024 the phase-out of AT1 as eligible bank capital, a move that will see the $40+ billion hybrid market effectively vanish by 2032. This impending change leaves investors facing the pressing challenge of finding suitable alternatives to replace the attractive yields and income that hybrids have traditionally provided.

Historically, the appeal of hybrids has not been solely due to their credit risk profile or the enticing spreads associated with higher-risk credit. A significant part of their yield advantage came from franking credits. As hybrids face obsolescence, investors must ask: what can effectively replace this income?

Transitioning to a global fixed income opportunity set as hybrids phase out

An analysis of 38 hybrid securities with an average call date in 3.5 years reveals current returns of 7.4%. However, these yields are expected to decline to around 6.7% over the next three to five years as cash rates fall. Investors should be aware that these hybrids carry elevated credit and tail risks, including the possibility of conversion into equity and substantial losses, even in scenarios where senior bonds recover.

As outlined in  “The “Magnificent 7” Reasons Why Now is a Good Time to Invest in Core Bonds”, we believe that today’s environment presents an opportune moment to transition from concentrated corporate credit risk, such as Australian hybrids, to a diversified portfolio spanning domestic and global fixed income markets. A simple 50/50 blend of active core bond and multisector credit funds, hedged to AUD, currently yields around 6%. This compares favourably to the expected 5.6% p.a. return for global equities over the next five years, based on PIMCO’s valuation-aware capital market assumptions.

In essence, we believe that a diversified portfolio of high-quality fixed income can deliver equity-like returns over the next five years while exhibiting only one-third of the risk associated with equities.

Optimising bond portfolios for income and risk appetite

We evaluated a broad range of strategies across Australian and global bond markets to identify alternative income sources, including:

  • Enhanced cash strategies, which aim to outperform the RBA cash rate by around 1% p.a. with low risk;
  • Core bonds that incorporate interest rate exposure;
  • Multisector credit strategies spanning investment grade, high yield, emerging market debt, and global securitised credit;
  • Niche allocations to capital securities (global equivalents of Australian hybrids); and
  • Up to 25% exposure to semi-liquid, multi-sector global private credit, which allows for quarterly redemptions and offers greater diversification than corporate direct lending.

We then conducted portfolio optimisations based on expected returns relative to tail risk. We capped private credit at 25% of the allocation and set other strategies’ weight between 10% and 40% to enforce meaningful diversification. (For more on expected returns and risk factors, see Appendix).

We compared a hybrid model (with and without franking credits) with two optimal portfolios (see Figure 1). The “hybrid yield matching” portfolio, which generates the same 6.7% expected return as the hybrid model, demonstrates that investors can match hybrids’ after-tax returns without franking credits, while reducing tail risk by approximately 20%.

The “lower risk” optimal portfolio allows more conservative investors to target a 6% return – close to the 6.7% return expected for hybrids and in line with our expectation for equities – while reducing their tail risk relative to hybrids by more than 50%.

Figure 1: Optimal portfolios could achieve higher returns, lower risk, or both, compared to hybrids

Figure 1 is a line chart that shows estimated return on the Y axis and estimated tail risk on the X axis. The line represents the efficient frontier, which shows the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return. The lower risk optimal portfolio has an estimated return of around 6% with less than 4% tail risk. The hybrid yield matching portfolio has a 6.7% estimated return with estimated tail risk around 6%. By contrast, the AU hybrid model has an estimated return of around 6.7% but with a higher estimated tail risk of around 8%. The AU hybrid model ex franking credits has a similar 8% estimated tail risk but expected return of around 5.75%.
Source: PIMCO as of 30 April 2025. Hypothetical example for illustrative purposes only. The efficient frontier is the set of optimal portfolios that offer the highest expected return for a defined level of risk or the lowest risk for a given level of expected return.

Examining the composition of the two optimal portfolios

Figure 2 shows the allocation and summary statistics for the two optimal portfolios targeting 6.0% and 6.7% returns, respectively. Daily liquid core bonds and multisector credit constitute the majority of both portfolios. The “lower risk” portfolio allocates a greater proportion to enhanced cash and slightly less to private credit. Both portfolios maintain modest interest rate risk, with durations around three years, half that of the Bloomberg Global Aggregate Index, the flagship benchmark for global bonds.

Figure 2: Allocations and summary statistics for two optimal portfolios

Figure 2 shows a pie chart and a table detailing key stats for the Lower risk optimal portfolio and a pie chart and table for the Hybrid yield matching portfolio. The lower risk portfolio contains 40% core bonds, 20% AU enhanced cash, 20% global diversified private credit, 10% global capital securities and 10% global multisector bonds. The estimated return is 6%, with estimated volatility of 4% and equity beta of 0.19. The hybrid yield matching portfolio contains 25% core bonds, 10% AU enhanced cash, 25% global diversified private credit, 10% global capital securities and 30% global multisector bonds. The estimated return is 6.7%, with estimated volatility of 5.3% and equity beta of 0.26.
Source: PIMCO as of 30 April 2025. Hypothetical example for illustrative purposes only.
1Unless otherwise specified, return estimates are an average annual return over a 5-year horizon. AUD cash return = 3.3%.
2Tail risk is measured using CvaR (95%, 1 year). Conditional value-at-risk (CvaR) is an estimate of the average expected loss beyond a desired level of significance. A positive value represents a loss.

These portfolios are diversified not only across asset classes, but also across risk factors. The “lower risk” portfolio, for example, sources around 40% of its risk from corporate debt, 20% from asset-based credit, and 25% from global interest rate exposure.

Hybrid investors often favour listed vehicles for their liquidity and transparency. The growing availability of active fixed income ETFs and private credit listed investment trusts (LITs) now offers accessible, liquid options that allow investors to transition smoothly from hybrids while maintaining diversified exposure. Such listed products provide a practical way to implement these proposed portfolio solutions without compromising ease of trading or portfolio flexibility.

Diversify beyond hybrids to secure equity-like expected returns in global fixed income

The phasing out of hybrids should be viewed as a catalyst for investors to explore global fixed income opportunities. When replacing hybrids, we believe that investors can maintain around 75% of their capital in daily liquid vehicles focused on multisector credit and core bonds, while allocating up to 25% to semi-liquid diversified private credit to enhance yields.

A diversified approach that extends beyond corporate credit risk to include additional risk factors such as interest rates, yield curve exposures, and securitized credit can deliver a superior risk-return profile compared to Australian hybrids.

Today’s high yields combined with attractive valuations across (predominantly non-corporate) credit markets provide an opportunity to lock in equity-like expected returns in high quality fixed income. This enables investors to de-risk portfolios without sacrificing returns, while enhancing diversification in equity-dominated portfolios.

APPENDIX

Understanding the risk-return profile of Australian bank hybrids

Hybrid securities carry greater credit risk than typical corporate bonds due to their subordinated status on the balance sheet. They also carry tail risk, including potential conversion to equity and material capital losses, even in scenarios where senior bondholders might recover their investments during severe crises.

By comparing the credit spread of hybrids relative to BBB-rated corporate debt with similar maturities, we estimate the credit risk premium in hybrids to be 75% higher. This risk premium difference serves as the key input for estimating risk in hybrids.

Additionally, the Australian hybrid securities market is more concentrated than diversified credit markets, with the top five issuers accounting for the majority of outstanding debt. We factor in this lack of diversification by attributing a 0.7% volatility contribution from idiosyncratic risk. 

Expected returns and risk factors in global fixed income markets

As Figure 3 shows, expected returns across income sources range from 4% to 9% p.a. When considering the franking credit advantage of hybrid securities, their risk-adjusted returns are in line with diversified multisector credit, private credit, and Australian BBB-rated credit.

The risk profiles of these strategies vary significantly in magnitude and composition, offering diversification benefits at the portfolio level – unlike hybrids, which are predominantly driven by corporate credit risk.

Figure 3: Summary stats and risk factor exposures in fixed income assets

Figure 3 features a chart showing the contribution to estimated volatility (in basis points per annum) of the risk factor exposures in the fixed income assets being used as building blocks for the optimal portfolios – ie. AU enhanced cash, core bonds, global multisector bonds, global capital securities, global diversified private credit and AU hybrids. Underneath the chart is a table that shows key statistics for each of the assets: estimated return, estimated volatility, Sharpe ratio, conditional value-at-risk, equity beta and duration.
Source: PIMCO as of 30 April 2025. Hypothetical example for illustrative purposes only.
1Unless otherwise specified, return estimates are an average annual return over a 5-year horizon. AUD cash return = 3.3%.
2Tail risk is measured using CvaR (95%, 1 year). Conditional value-at-risk (CvaR) is an estimate of the average expected loss beyond a desired level of significance.
3Other factors includes: EU sovereign spread, swap spread and currency.


1 As of 30 April 2025. Yield tends to be a good predictor of future returns as the correlation between YTM and 5-year future total returns of the Bloomberg US Aggregate Index is 94% based on data from 1976 to 2025.

2 Based on valuations as of 31 March 2025 (US Aggregate Bond Index yield > 5% and the cyclically adjusted price-to-earnings ratio for the S&P 500 >30, future 5-year median returns are 7.8% p.a. for bonds and -0.8% for equities). This analysis uses data from January 1973 to the date of publication.

3 We find tail risk to be a more valuable measure of risk, particularly for credit investments that tend to exhibit more left tail events than a normal distribution suggests. Specifically, we use the Conditional Value at Risk over a one-year horizon with 95% confidence as our tail risk measures. It estimates the worst annual return over a 20-year horizon.

4 We follow a duration x spread approach and multiply the credit spread duration of 3.56 years in the AusBond Credit BBB 3-5 Years by ~1.75 to estimate the sensitivity of hybrid securities to Australian BBB spread levels.

Featured Participants

Robert Mead
Co-head of Asia-Pacific Portfolio Management
Adam Bowe
Head of Australia Portfolio Management
Fabian Dienemann
Quantitative Research Analyst

PIMCO Australia

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