Martin Smith l AUSIEX Fixed Income

Bank hybrids are being phased out of APRA’s regulatory capital framework, and Tier 2 subordinated debt is expected to play a significant role in this transition. For advisers, this presents an opportunity to reconsider how clients obtain fixed-income exposure, including whether directly held bonds may offer advantages over pooled investment vehicles. 

The dates are not forecast

From 1 January 2027, APRA's revised framework will cease recognising newly issued AT1 instruments as eligible regulatory capital. Existing eligible AT1 instruments will continue to receive transitional regulatory treatment until their first scheduled call date, with those dates occurring by 2032. Importantly, these instruments remain subject to their existing legal terms and a first call date does not guarantee redemption. 

The regulatory transition is settled. The precise timing of individual redemptions is not. 

The ASX-listed hybrid market is roughly $40 billion, predominantly major bank AT1. Many investors, including SMSFs, hold these securities. Every holder faces the same question: when these securities are redeemed, what replaces them? 

The scheduled first call dates provide a practical planning horizon for advisers, although actual redemption remains subject to the terms of each security, the issuer’s decision and any regulatory approvals.

What APRA put in its place

Under APRA's final framework, major banks replace the 1.5% AT1 requirement with 1.25% Tier 2 capital and 0.25% CET1. Smaller banks can replace AT1 entirely with Tier 2. 

APRA concluded that AT1 was less effective than intended in a banking crisis and decided to replace its prudential role with Tier 2 capital and, for larger banks, CET1. Tier 2 is generally issued as dated subordinated debt carrying contractual interest. However, it remains exposed to issuer credit risk and loss-absorption provisions. 

Banks have already responded to the change. Tier 2 issuance has expanded and will continue expanding throughout the transition. 

The key question now is who will own these securities. 

Everyone answering this question has a product

There is no shortage of people offering answers to the hybrid replacement question, ourselves included. That makes it worth looking past the sales pitch and comparing what each option actually delivers. 

Most proposed solutions replace a direct holding with a pooled vehicle. Before doing that, it is worth asking what clients actually valued about hybrids. 

For most investors it was not the capital structure or conversion mechanics but the simplicity i.e. 

• A well-known issuer 

• A stated margin over BBSW 

• A scheduled call date 

• Quarterly income 

• Franking credits 

• Direct exposure to an individual security

Some of that may have created a false sense of safety. Most of it did not. It gave investors information they could easily understand. 

Managed funds offer an alternative, often providing diversification and professional management. But they also introduce another layer between the investor and the underlying securities. Distributions can vary, fees affect returns, and the value of the investment depends on the unit price when the investor exits.  

For investors who value knowing exactly which bonds they own, the income those bonds pay and when they mature, direct ownership can be an attractive alternative. That transparency comes with the responsibility of selecting and monitoring individual securities.  

A direct alternative worth considering 

A client moving from a major bank hybrid into the same bank's Tier 2 bond from the same banking group may retain many of the features they valued, with some important advantages: 

• Familiar issuer 

• Higher ranking in the capital structure 

• Defined maturity and potential call dates 

• Contractual coupon payments rather than discretionary distributions 

• No AT1-style capital-ratio conversion trigger 

Tier 2 bonds are not without risk. If a bank becomes non-viable, they can still be converted into shares or written off. However, they generally offer a simpler structure, greater certainty around contractual income and a defined maturity date.  

For many investors, this is not necessarily a compromise. Tier 2 offers a higher position in the capital structure while preserving several of the features that made hybrids attractive in the first place. 

Once advisers become comfortable owning individual bonds, I believe the opportunity set expands much further. Senior bank debt may fulfil a defensive role, while corporate issuers provide diversification away from portfolios already concentrated in Australian banks through equities, term deposits and hybrids. 

The hybrid phase-out creates an opportunity to address that concentration because the capital is moving anyway. 

The hybrid’s headline rate is not cash 

One of the biggest misconceptions in the debate on hybrids replacement is how income is compared.  

For many bank hybrids, the quoted distribution rate includes the value of franking credits (depending on the specific data source). The amount investors receive in cash is therefore lower than the headline rate.  

Using illustrative numbers: 

• BBSW: 4.55% 

• Hybrid margin: 2.50% 

• Grossed-up distribution: 7.05% 

Consider the following illustrative example: 

Assuming the distribution is fully franked at 30%, the investor receives approximately 4.93% in cash, with the remaining 2.12% represented by franking credits. Now compare that with a Tier 2 bond from the same issuer paying BBSW plus 2.00%. Its coupon would be 6.55%, paid entirely in cash. 

The Tier 2 bond delivers more immediate cash income in this example. However, the overall return will also depend on the value of franking credits, tax treatment, purchase price and the different risks of each investment. 

Specifically for SMSFs in pension phase, refundable franking credits can eventually make up the difference. For investors unable to fully utilise credits, some value may never be recovered. 

The lesson here is quite simple: compare cash yield with cash yield first, then assess the value of franking credits separately. 

If the hybrid trades above face, check the yield to call 

Many bank hybrids have historically traded above face value. When that happens, investors often focus on the distribution rate and ignore the yield to call. 

If a hybrid is redeemed at $100, an investor who purchased it above face value will lose that premium. This can significantly reduce the return earned over the holding period.  

That means investors holding a hybrid at a premium may be earning substantially less than the advertised distribution suggests. 

This does not automatically justify selling today. Exiting early means forgoing future distributions and may create tax consequences. 

However it does mean advisers should consider calculating yield to call and compare it with available alternatives rather than simply waiting for redemption. 

The three principal objections 

Minimum Parcel Sizes 

Historically, wholesale bond markets required institutional-sized investments. Fractionalisation has largely solved this problem. 

Clients can now access institutional bond lines from around $10,000, allowing diversified portfolios across multiple issuers and maturities. 

Liquidity 

Liquidity matters most when investors intend to sell. 

One advantage of a bond with a stated maturity is knowing when principal is scheduled to be repaid. Investors who can hold to maturity may be less dependent on daily market liquidity. However, repayment still depends on the issuer meeting its obligations, and investors who need to sell early may face lower prices or limited buyers. 

Administration 

This remains the most practical consideration. 

Historically, direct bonds often sat outside consolidated reporting systems. Today, custody and administration services can integrate bond holdings, transactions and coupon payments into the same reporting platforms advisers already use. 

The key question is no longer whether infrastructure exists, but which provider best fits the practice. 

Wholesale and retail are not the same conversation  

An important distinction is often overlooked in my experience. 

Many new bond issuance occurs under wholesale investor exemptions and are therefore primarily available to wholesale clients at launch. 

Wholesale investors can access new issues at issue margin and build portfolios directly from primary markets. 

Retail investors, however, operate in a smaller universe. Securities issued without retail disclosure cannot simply be passed through to retail clients until relevant restrictions expire or disclosures are provided. 

This creates two practical implications: 

• Firstly, many clients who qualify as wholesale investors have never completed the certification process. Obtaining wholesale status can significantly broaden investment options however wholesale investors do not receive all the protections available to retail investors. 
• Secondly, the retail market is often larger than advisers assume. The more useful question is which bonds are available. 

In many cases, the answer is more extensive than expected. 

Running the transition 

The advisers who navigate this change best will prepare well ahead of their clients’ scheduled hybrid call dates. 

A practical approach you can consider is as follows: 

1. Inventory the hybrid book - Record the call dates, prices and yield-to-call figures. 

2. Test the timing - Determine whether waiting for redemption is optimal for the client. 

3. Decide before cash arrives - Cash balances have a habit of becoming permanent. 

4. Ladder maturities - Consider matching bond maturities to client objectives rather than redemption dates. 

5. Split allocations deliberately - Use Tier 2, senior debt and corporate bonds for different portfolio objectives. 

6. Fix operations early - Establish the custody, reporting, execution processes and wholesale certifications before funds are redeemed. 

It will be operational readiness that will determine whether advisers execute a considered strategy or default to whatever is easiest on the day. 

Does the file note write itself? 

The advice rationale is straightforward. 

APRA's decision provides a clear reason to review existing hybrid holdings. But it does not automatically make Tier 2 the right replacement for every client. 

The advice rationale should explain how the chosen investment fits the client's objectives, income needs and attitude to risk, including why it is preferred over the available alternatives. Whether advisers ultimately use direct bonds, funds, or a combination of both, the key point remains unchanged. 

The forcing event has arrived 

Between now and 2032, existing bank AT1 hybrids will reach their first scheduled call dates. APRA expects banks to transition away from these securities, with Tier 2 bonds playing a significant role in replacing them within bank capital structures. While redemption is not guaranteed, banks have a strong incentive to redeem existing hybrids as they cease to count towards regulatory capital. 

The remaining question is how advisers and their clients choose to respond. Direct bonds offer the appeal of a known issuer, contractual income and a stated maturity date. Managed funds offer diversification and professional management. Both have their place, but for clients who value knowing exactly what they own, direct bonds deserve serious consideration. 

Sometimes, simplicity and transparency are exactly what the client is looking for. 

 

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This information has been prepared by Australian Investment Exchange Limited (AUSIEX) ABN 71 076 515 930 AFSL 241400, a wholly owned subsidiary of Nomura Research Institute, Ltd. (NRI). AUSIEX is a Market Participant of ASX Limited (ASX) and TMX Australia Exchange Pty Limited (TMX), a Clearing Participant of ASX Clear Pty Limited and a Settlement Participant of ASX Settlement Pty Limited. 

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