Understanding bank hybrid securities
AT1 capital securities (bank hybrids) have become a mainstay of retail investors’ portfolios due to their attractive returns, franking tax benefits and perceived safety. This retail demand has in turn helped maintain low yields and favourable funding conditions for Australian banks. Despite their popularity with retail investors, bank hybrids are complicated products that were originally established to manage liquidity and contagion shortcomings revealed by the Global Financial Crisis. This mismatch between the security complexity and large-scale retail investor adoption has ultimately culminated in a decision by The Australian Prudential Regulation Authority (APRA) to phase out bank hybrids by 2032. Because of that, most outstanding securities will be called in less than 5 years. Below we discuss the reasons behind the phase-out, how the phase out will unfold, and why now is the time for retail investors to consider reallocating their bank hybrid exposure to Australian high yielding credit.
What are bank hybrids?
Additional Tier 1 Capital, or “Bank Hybrids” as they are more commonly known, were introduced as part of the Basel III regulatory framework, which was developed in response to the Global Financial Crisis of 2007–2008. Fundamentally, the purpose of hybrid capital was to:
- strengthen global financial system resilience by supporting bank solvency in any subsequent financial crisis;
- enhance loss absorption, ensuring a bank can remain a going-concern through a potential crisis;
- reduce Government bailouts, by increasing a bank’s capital buffer ensuring any losses are absorbed by investors and not taxpayers; and
- add a clearly defined layer between common equity and junior subordinated debt, which in theory should make the hierarchy of capital clearer to both regulators and investors.
The mechanisms embedded in the instruments include:
- Discretionary coupon payments that can be cancelled or deferred.
- Potential conversion of the bond to equity or completely written-off.
Why did APRA decide to phase out bank hybrids?
Given hybrid securities in Australia are largely held by retail investors, APRA has been concerned about the ability of the Domestically Systemically Important Banks to effectively utilise the conversion and/or write-off provisions to stabilise the capital base in a crisis. As such, the rationale behind APRA’s decision to remove AT1 from the bank capital structure includes improving capital strength and simplifying the capital structure.
“Capital is the cornerstone of the banking system’s ability to withstand financial stress. While Australia’s banks are unquestionably strong, overseas experience has shown AT1 doesn’t operate as intended during a crisis due to the complexity of using it, the potential for legal challenges and the risk of causing contagion.*
- APRA
Implications for Investors
As of today, there are approximately $43bn in major bank retail bank hybrids outstanding. The chart below shows that over a quarter (27%) of the outstanding securities will be called in less than 2 years and over three quarters (76%) will be called in under 5 years.
Domestic retail investors hold an estimated 30% of the available bank hybrid securities in Australia. While it’s commonly known that these securities will no longer be available post their call dates, with the final call date being 2032,there are a few reasons why investors should be considering their current position in hybrids now, rather than deferring until the call dates.
Diminishing liquidity
- As a bond nears its redemption date, most of its price risk due to interest rate fluctuations diminishes, making it less attractive to traders seeking to profit from price movements. Therefore traders have significantly reduced interest in trading these securities.
- The pool of potential buyers shrinks. Many retail and institutional investors and funds, particularly those with minimum maturity requirements, may no longer be interested, as the soon-to-mature bond may not fit their portfolio objectives.
With only a small number of coupon payments remaining, the incentive for investors to buy and hold is reduced, resulting in lower trading volumes and wider bid-offer spreads. As a result, market participants may find it more difficult to buy or sell the bond without affecting its price. In simple terms the bond becomes more expensive to trade.
Potential for capital losses
As many of the remaining retail AT1 bank hybrids are trading above par, investors holding bank hybrids at a premium (i.e. above par) may face a loss, as the call price or par value is lower than the market price they paid or are currently holding at. We already know that any future coupon payments expected from holding these bonds to maturity will not materialise past their call date as it has already been determined by APRA that these securities will be called. This scenario can lead to a negative return compared with holding a non-callable bond. This is an important risk consideration for investors holding highly priced callable bonds, like AT1 bank hybrids as the call date approaches.
Compelling opportunities outside of bank hybrids
Investors who are concerned about replicating returns they have received on bank hybrids may be hesitant to review their position, however it is important to highlight that other compelling income opportunities exist outside of pure bank hybrids, which can offer commensurate returns, greater diversification and lower volatility.
What is the replacement for Bank hybrids?
Australia is blessed with a corporate credit index that exhibits quality characteristics from an investor’s perspective. Well diversified with high levels of regulation, inflation pass-through mechanisms, monopolistic operating conditions, and a stable and predictable legislature all provide an outstanding investment environment to investors seeking to reduce their bank hybrid exposure whilst maintaining higher yielding returns without the volatility of traditional equities.
Global macroeconomic conditions are challenging and are likely to remain as such for some time. Whilst Australian credit spreads have widened significantly from their tights in February this year, reflecting the more volatile environment under Trump 2.0 and his sweeping “Liberation Day” announcements, we have seen performance coming through. Spreads however, have not retraced as significantly as seen in both the US investment grade and high yield markets. US spreads remain at risk of further widening in an environment where interest rates are likely to be held higher for longer. Conversely, Australian rates have already started to loosen, which highlights that now is the time to invest in Australian credit to capture the capital gains and lagging spread performance.
Schroder High Yielding Credit Fund (CBOE: HIGH)
Through exposure to the typically defensive wholesale high yielding credit universe, the Schroder Australian High Yielding Credit Fund (‘the Fund’) answers the call of retail investors who are looking for ungeared, higher yielding income solutions beyond diversified, traditional equity and cash-based products, while seeking to avoid the liquidity and transparency challenges associated with private markets.
Importantly, it serves as an ideal substitute for existing bank hybrid exposures by providing a comparable return profile with the added benefits of diversification and access to the high quality Australian credit market spanning senior and subordinated financial and corporate credit.
In short, the Schroder High Yielding Credit Fund (CBOE: HIGH), offers investors the opportunity replace their concentrated and expensive bank hybrid exposure today, with significantly lower volatility.
A note on Gearing
Fixed income investors, particularly those focused on income and capital stability, are likely to find geared funds inappropriate for their risk profile and investment objectives. The Schroder Australian High Yielding Credit Fund does not used gearing to enhance returns for the following reasons:
- Gearing can amplify potential returns but also losses.
- In volatile and uncertain markets like we have today, declining markets can result in large drawdowns that are difficult to recover from. The borrowing costs to leverage a fund erode returns especially if the yield earned does not exceed the cost of funds, which will increase in risky markets.
- Geared investments add complexity risk due to the use of derivative products or borrowing arrangements, which may reduce transparency and make it harder to fully understand the fund’s risks and exposures.
In general, geared funds generally introduce risk and other characteristics that are not aligned with the traditional goals of the defensive portion of an investment portfolio.
Read the latest thought paper from the portfolio manager, Helen Mason: Replacing bank hybrids: The time to act is approaching
Disclaimer
*APRA. December 9 2024. A more effective capital framework for a crisis: Update
The information contained in this material is general information only and does not take into account your objectives, financial situation or needs. Before acting on the information contained in this material you should consider the appropriateness of the information in regard to your objective, financial situation and needs before making any decision about whether to invest, or to continue to hold an investment.
The repayment of capital and performance of an investment is not guaranteed by Schroders or any other party. Opinions constitute our judgement at the time of issue and are subject to change. Past performance is not an indicator of future performance. Investment guidelines represented are internal only and are subject to change without notice. Schroders may record and monitor telephone calls for security, training and compliance purposes.