Changes ahead for bank hybrid securities

The Australian Prudential Regulation Authority (APRA) has announced major changes to the structure of bank hybrid securities, which have been used as a defensive investment for some retail investors for years.

From the beginning of 2027, banks will no longer issue Additional Tier 1 (AT1) hybrid securities, APRA expects a phase out of these securities by 2032. Importantly, the changes only impact bank issued hybrids; securities issued by insurers and other companies are not impacted.

These changes are significant for bank funding and investors that have used hybrids for tax-effective income for years. Here, we outline the changes and what it means for investors.

Why is APRA phasing out hybrids?

APRA has been concerned about retail investors' exposure to these complex securities for some time. The collapse of Credit Suisse in 2023 highlighted just how risky these instruments can be.

APRA's decision to phase out AT1 hybrids aims to simplify the capital structure of banks and reduce the risk for retail investors who may not fully understand the complexity and potential downsides of these investments.

In Australia, a large portion of the hybrid market is held by retail investors. Hybrids are designed to absorb losses during periods of financial stress. APRA’s move aims to shift banks towards simpler and more reliable forms of capital, including Tier 2 (T2) bonds and higher levels of equity.

What will replace AT1 Securities?

In the future, AT1 hybrids will be replaced by Tier 2 bonds and additional equity buffers to ensure banks remain financially resilient. However, Tier 2 bonds are generally not available to retail investors, as they are typically issued in over-the-counter markets and primarily targeted at institutional investors.

This means that retail investors will largely miss out on participating in these securities, while systemically important banks will (marginally) increase their reliance on common equity as the same time.

Potential risks for retail investors

The reduction in retail access to hybrid securities could lead to unintended consequences. With the universe of lower-risk, income-generating securities available, some retail investors might turn to higher-risk alternatives, such as complex credit instruments. These alternatives can carry different and possibly higher credit risks, management fees, and more opaque structures, making them less suitable for some investors.

Both APRA and ASIC have expressed concerns about investors moving into these riskier products without fully understanding the potential downsides, such as liquidity risks and pricing volatility. As a result, it’s essential that investors remain cautious about chasing higher yields without a thorough understanding of the risks involved.

Our approach to hybrid securities

We have taken a more selective approach to recent hybrid issuances. These offerings have become increasingly difficult for retail investors to access, with demand often outstripping supply. Additionally, the margins offered on newer hybrids have been less attractive compared to previous issuances, reducing their appeal for income-focused investors.

While concerns over investor treatment in extreme scenarios, such as what occurred with Credit Suisse, have been noted, the robust regulation and oversight of the Australian banking system have largely mitigated these risks. Nonetheless, we remain cautious in evaluating these securities to ensure they align with clients' best interests.

What does this change mean for your current hybrid securities?

For now, investors will be able to continue to hold existing hybrids and enjoy the income they generate until their first call date or maturity.

These securities will not change until they are phased out by 2032, and no immediate action is required. However, it’s important to plan ahead and consider relevant next steps.

Hybrids remain eligible until their call date: Any existing bank hybrids will continue to function as they have, providing income until maturity. There’s no rush to make changes at this stage.
Reduced liquidity in the future: As fewer hybrids are issued, liquidity may become a concern. Investors may find it harder to sell their hybrids closer to the call date, so it’s worth considering whether holding until maturity is the best option.

What are investors’ options?

As the hybrid market changes, investors will have a few options depending on their goals and risk tolerance:

Hold until maturity: If funds aren’t needed immediately, holding the hybrids until maturity or the first call date could be the simplest approach. Investors will continue to receive the income they provide for the time being.
Explore alternative income options: While hybrids may be phased out, there are still other investments available for income generation, such as floating rate bonds or other managed or listed alternatives. These can provide more stability but may offer lower yields. Be cautious of riskier products which may be more complex and less transparent.
Sell if liquidity is a concern: If investors anticipate needing access to their funds sooner, it may be wise to sell the hybrid security/ies before liquidity declines. As the market for hybrids winds down, trading volumes may fall, and it could become more difficult to sell later on. Having said that, the immediate reaction has seen some prices increase as investors get set to benefit from the appealing income before the hybrids are phased out.

APRA’s changes to the hybrid market are designed to protect retail investors, but they also reduce access to a familiar investment product. While there’s no need to make immediate changes, it’s important to understand the risks and opportunities that lie ahead.

As always, we are here to help navigate these and other changes and make the best decisions for portfolios. Please reach out to your FMD Adviser if there is anything of interest in this article.

General advice disclaimer: This article has been prepared by FMD Financial and is intended to be a general overview of the subject matter. The information in this article is not intended to be comprehensive and should not be relied upon as such. In preparing this article we have not taken into account the individual objectives or circumstances of any person. Legal, financial and other professional advice should be sought prior to applying the information contained on this article to particular circumstances. FMD Financial, its officers and employees will not be liable for any loss or damage sustained by any person acting in reliance on the information contained on this article. FMD Group Pty Ltd ABN 99 103 115 591 trading as FMD Financial is a Corporate Authorised Representative of FMD Advisory Services Pty Ltd AFSL 232977. The FMD advisers are Authorised Representatives of FMD Advisory Services Pty Ltd AFSL 232977. Rev Invest Pty Ltd is a Corporate Authorised Representative of FMD Advisory Services Pty Ltd AFSL 232977.