The Australian Prudential Regulation Authority (APRA) has mandated the elimination of bank hybrids by 2032, setting in motion substantial changes to Australia’s fixed income market. This decision affects the $43 billion bank hybrid market where retail investors currently hold between 20-30% of all ASX-listed hybrids – instruments that many may not fully understand despite their popularity.

Understanding Bank Hybrids

Bank hybrids occupy a unique position in capital structures, blending elements of both debt and equity. These securities pay regular distributions, typically quarterly, at a fixed margin above the bank bill swap rate. Their appeal lies in their yield enhancement and franking credit benefits, but this often comes with hidden risks. When banks face severe financial stress, the Common Equity Tier 1 capital ratio can fall below trigger points (around 5.125%), at which point hybrids can face significant impairment.

The Credit Suisse crisis of 2023 provided a stark real-world example of hybrid risk. When UBS took over Credit Suisse in a US$4.3 billion deal, Credit Suisse’s Additional Tier 1 bondholders faced complete write-offs rather than having their securities converted to ordinary shares. This outcome shocked many investors, as shareholders received partial value while supposedly higher-ranking hybrid holders received nothing – contrary to traditional capital ranking expectations.

Banking Sector Adjustments

Banks now face the task of replacing approximately 1.5% of their capital structure, currently filled by hybrids. APRA requires this gap to be filled with 1.25% Tier 2 bonds and 0.25% common equity. This shift creates a simpler, two-tiered capital structure that is designed to function more predictably during financial crises.

The removal of hybrids from bank capital structures directly addresses the loss absorption confusion witnessed during the Credit Suisse collapse. By eliminating this middle-tier capital instrument, APRA aims to create clearer hierarchies during potential bank failures and reduce systemic risk in Australia’s financial system.

Market Pricing Shifts Already Underway

Since APRA’s announcement, market pricing has shown notable changes. Hybrid capital prices have increased significantly as investors recognise the shrinking future supply of these instruments. Conversely, Tier 2 bond spreads have begun to widen as the market adjusts to the prospect of increased issuance and the loss of hybrids as a capital buffer.

For investors, this transition means losing access to credit instruments that typically yield 2-2.25% above the bank bill swap rate, along with valuable franking credits. This double impact on income returns represents a significant change for those who have relied on bank hybrids as part of their income strategy.

Alternative Fixed Income Options

Several alternatives exist in the Australian market, though none perfectly replicate the risk-return profile of bank hybrids.

Corporate hybrids from non-bank issuers such as Ampol, Ausnet, Aurizon, and Scentre Group provide regular distributions without franking. These instruments sit above equity but below senior debt in capital structures and generally offer higher yields than bank hybrids on an unfranked basis. Unlike bank hybrids, these trade in the over-the-counter bond market.

Subordinated Tier 2 bonds represent another option, ranking above both equity and hybrids in bank capital structures. Banks have no discretion on interest payments for these bonds unless they become non-viable. While offering lower yields than hybrids due to their lower risk profile, these instruments provide greater certainty during stress periods.

European and Asian banks issue Contingent Convertible bonds (CoCos), which function similarly to Australian bank hybrids. Depending on the jurisdiction, these may carry different conversion provisions and can present varying risk profiles compared to Australian hybrids. The Credit Suisse case demonstrated that CoCos can face complete write-downs in severe scenarios.

For those seeking professional management, credit funds provide exposure to diversified bond portfolios. Available as closed-end (such as LITs, LICs) or open-end (such as unlisted managed funds, ETFs), these vehicles offer professional oversight but charge management fees that impact returns.

Bank ordinary shares represent the highest-risk alternative, sitting behind all debt holders in the capital structure. While dividend payments fluctuate with bank performance and may be cut entirely in extreme circumstances, these typically come with franking benefits similar to hybrid distributions. Share prices tend to show greater volatility as they reflect changing profit outlooks.

The Road Ahead

The phase-out of bank hybrids marks a significant shift in Australia’s fixed income market. Investors accustomed to these instruments must now evaluate alternatives based on their individual income needs and risk tolerance. The good news lies in the variety of replacement options available, though each comes with its own distinct risk-return characteristics.

For the financial system as a whole, APRA’s decision represents a move toward greater stability and transparency in bank capital structures. By learning from the Credit Suisse experience and proactively addressing potential confusion about loss absorption hierarchies, Australian regulators aim to strengthen the banking system against future financial shocks.

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