Bank hybrids could remain a worthwhile investment until they are phased out in 2032 – and may prove even more attractive as opportunities become limited to the secondary market.

The Australian Prudential Regulation Authority (APRA) confirmed on December 9 that it would require banks to phase out their use of hybrid capital after a consultation period in which it had discussed its initial proposal with industry stakeholders.

Australia is an international outlier in that a high proportion of bank hybrid owners are retail investors. More than half of the local market is held by people with parcels of less than $500,000, according to APRA, and advisers may ultimately need to help funnel that capital into other investments. 

The United Kingdom, European Union, Switzerland and Canada had already restricted or banned retail ownership of similar securities.

All sorts of investments have been touted as alternatives to bank hybrids as a result of APRA’s decision. Corporate hybrids, subordinated bank debt, private debt and structured products are among the options put forward as alternatives for income-hungry investors. 

But Campbell Dawson, Director at Elstree Investment Management, argues it would be premature to discount the inclusion of bank hybrids in portfolios in the years leading up to 2032.

“Hybrids in general have the best risk adjusted return (around 7%), or combination of risk and return, of any listed asset class over the past 10 years. Equities have delivered around 1% more but with volatility that is around five or six times higher,” Dawson says.

Secondary trading

He says there may even be more reason to hold bank hybrids than before, as they appear under-priced relative to the margins at which they’re offered. There will also be no new issues as a result of APRA’s ban, which may drive demand in the secondary market.

Elstree is one of the handful of managers offering specialised hybrid funds for retail investors and has been in operation for more than 20 years. One of its vehicles is the Elstree Hybrid Fund (CBOE: EHF1) which aims to deliver a return over short term interest rates over a three-year period by creating a diversified portfolio and taking advantage of market inefficiencies.

Elstree forecasts that returns from hybrids may be 6-6.5% over the next two to three years, which “is still a good outcome,” says Dawson.

“We can’t see much weakness for the simple reason that demand will flow through into secondary trading,” Dawson says. 

“Around $5 billion of hybrids will mature over the next 12 months. Typically, whenever there’s a new issue, around 50% of it goes to people who had held the previous issue. Now they may turn to other bank hybrids that are already listed on the ASX.”

Beyond 2032

As for the longer term, Yarra Capital Management argues that corporate hybrid issuance on the ASX could ultimately resurge to help fill the gap left in the local market by bank hybrids. 

The Melbourne-based fund manager pinpoints blue chip energy and infrastructure companies – like AGL, Origin, APA and Transgrid – as potential hybrid issuers due to the $400 billion investment required to decarbonise the energy market by 2050.

“It is highly unlikely that equity alone will foot the bill for these expensive projects and that is why we see hybrids as an increasingly popular funding source in Australia’s transition to a low-carbon economy, offering flexibility and capital efficiency,” Yarra’s Co-Head of Australian Fixed Income, Roy Keenan, has written.

“For large-scale energy transition projects, such as new transmission lines and renewable energy facilities, hybrids offer a way to fund significant upfront capital costs without putting undue strain on a company’s balance sheet,” he says.

Waiting game

Other analysts have suggested subordinated bank debt could play a bigger role in retail portfolios as bank hybrids disappear, though today the former is largely an institutional asset class. Only a handful of existing exchange traded funds – such as VanEck’s Australian Subordinated Debt ETF (ASX: SUBD) and Betashares Australian Major Bank Subordinated Debt ETF (ASX: BSUB) – have a sole focus on it.

Others still suggest that diversified fixed income funds, which use a range of bond and credit strategies, might be an option for more clients in the years ahead.

The reality, though, is that advisers do not need to make immediate decisions: “We ask advisers: what are you going to do? The initial answer generally is ‘this is still some years away’,” Dawson says.

“The one thing I think is guaranteed is there won’t be any bank-type papers listed on the ASX. Exposure to those assets will need to be via funds or ETFs.”

Product issuers may eventually launch a wave of new investments to capture capital that previously went to bank hybrids. In the meantime, existing banks hybrids could remain a valuable addition to portfolios. 

For other hybrids trading insights or to speak with a member of the AUSIEX Capital Markets team please get in touch with us at CapitalMarkets@ausiex.com.au.