Australian Bank Hybrids: Navigating the Transition to Alternative Income Sources

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%.^Footnote1 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.^Footnote2

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^Footnote3. 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%.

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.

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.^Footnote4

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.