Why bank hybrids are being phased out and what it means for investors

It is not every day that a super popular investment opportunity slowly dries up and disappears.

However, that is exactly what is happening to the many thousands of investors who have flocked to invest in hybrid securities issued by the major banks.

In total investors have an amazing $43 billion invested in bank hybrids, which in effect are a combination of debt and equity and usually pay up to 3% above the bank bill rate.

Phase out to reduce financial system risk

The reason hybrids will be gradually phased out by 2032 is not because they are unpopular with investors – far from it – but because the prudential regulator has simply called time on the whole concept because in their judgement it causes too many risks to the financial system in the event of a crisis.

One of the great recent examples of this risk was the wipeout of investors in Credit Suisse hybrids, who faced an entire loss of capital when the deeply troubled banking giant was forced to merge with UBS.

Regulator reacts to Credit Suisse hybrid bail-in

That event was the final straw for Australian Prudential Regulation Authority (APRA) chair John Lonsdale and his fellow board members and the entire suite of local hybrids was forced into wind down mode, with no more hybrids to be issued by the big banks.

There has been some protest action about closing down this asset class but it seems likely that the regulator is not for turning and hybrids will gradually wind down.

The decision has annoyed many investment advisers who believe that the hybrid market has been operating very successfully for more than 20 years and should have been allowed to continue because Australian banks are very different to European ones.

One of the particular attraction of hybrids is that they not only offer an excellent investment yield but they also pay investors around $1 billion in franking credits every year.

Great way to access franking credits

Those franking credits are treasured by retirees and other no or low tax investors such as superannuation funds because they allow for the credits to be repaid through the tax system.

The phase-out comes after months of consultation and was influenced by the Swiss regulators decision to bail-in investors in Credit Suisse hybrids when that bank ran into difficulty and was taken over by UBS in March 2023.

APRA chairman John Lonsdale said replacing hybrids – known as additional tier-1 capital instruments or AT1 – with other forms of capital would mean banks are better able to respond to future crises without taxpayer support.

“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.”

Mr Lonsdale said there will be no overall increase in capital requirements for banks, and APRA expects funding costs to be neutral to marginally higher for the five largest banks and slightly lower for all other banks.

Large banks will be able to replace 1.5% of capital from hybrids with 1.25% of tier-2 subordinated bonds and equity worth 0.25%.

Smaller banks will be able to fully replace hybrids with tier-2 bonds and a reduction in tier-1 capital requirements.

Advisers fear investment risks will rise

Some financial planners and investment managers fear the scrapping of new hybrids will push investors further up the risk curve and make it harder for investors to access franking credits.

So what alternatives are around that might fill the gap for investors?

Well, the most obvious is for investors to buy shares in the banks themselves, although this does mean taking on more investment risk because shares can obviously rise and fall with general and specific market movements.

The bank dividends will also be lower than the rates offered for hybrids and thus have a lower attached franking credit than was available on the hybrid market.

Another alternative would be other shares offering solid dividends and franking credits or one of the many dividend funds, ETFs or listed investment companies that offer access to franked dividends.

At the safer end of the risk curve in terms of capital preservation is a term deposit, cash trust or a product like Betashares Australian high interest cash (ASX: AAA) that all pay interest and preserve capital, although the returns will be lower than hybrids.

For a slightly higher yield, there are still some ways to access the subordinated bank debt market with perhaps the most accessible being Betashares Australian major bank subordinated debt (ASX: BSUB).