Prudential regulator, Australian Prudential Regulation Authority (APRA), announced at the end of last year that AT1s – also known as hybrid bonds – will be phased out in 2027 as the regulator was concerned about their reliability and complexity in a future crisis. This is because they carry greater credit risk than corporate bonds due to their subordinated status in the capital structure.
The Australian hybrid market is also more concentrated than other markets globally, with the top five issuers accounting for the majority of outstanding debt.
But AT1 hybrids are popular with private wealth and retiree clients for their consistent, franked income, and there are currently $44 billion in issue. With franking credits, they have traditionally offered yields of 5–7 per cent.
Speaking to Money Management, two advisers have shared where they expect to move their clients’ money once the phase-out is complete.
Rather than simply trying to move clients’ assets to another investment that is similar to their existing AT1 holdings, Viola Private Wealth’s chief investment officer, Daniel Kelly, said advisers should instead consider “what role those hybrids were intended to play in their portfolio, and how best to replace that building block within their overall strategy”.
“Broadly speaking, the benefits hybrids offered investors included defensive and predictable income, low-duration floating rate exposure, liquidity, and ease of access through a listed vehicle. Fortunately, there are a number of alternative options available that can also fulfil these roles.”
Taking a similar view, Roger Perrett, partner and founder of Freshwater Wealth, said there was no singular asset that could cleanly replace hybrids and match their traits, agreeing with Kelly that advisers should first consider why they held AT1s to begin with.
“I believe the replacement for hybrids depends on what was the role of holding them in clients’ portfolios. If investors liked the higher income returns and defensiveness, we need to recommend assets that can deliver those outcomes,” Perrett said.
Looking at how assets might be reallocated, Kelly suggested that Tier 2 instruments will become the “highest-yielding part of a domestic bank’s capital stack”, triggering a significant inflow into that sector as advisers seek a replacement for major bank credit risk in portfolios.
Even so, he believes a lot of advisers may also look to investment grade private credit to produce a similar level of return in a diversified manner but with low levels of volatility, though Kelly also cautioned that extensive due diligence is still required.
“If you are replacing major bank credit risk, you need to know what you are putting in its place.”
While he said he doesn’t hold any great issue with how AT1s are being phased out, Kelly said he is particularly concerned for retirement-phase investors that have the majority of their capital invested in AT1 securities, stating that some relied exclusively on them as a way to generate tax-efficient retirement income, leading them to hold “larger-than-typical exposure to the sector”.
“It is very important that those investors seek advice if and where needed to ensure they are not rotating the capital blindly into options that are producing similar levels of yield but carry significantly more risk.”
Perrett flagged the timing of the transition is also an important consideration as advisers may yet choose to continue holding hybrids and act closer to the “call date”, or sell them now and lock in the capital gains.
For those that choose to hold, Perrett said there is no additional risk from doing this and suspects most investors will potentially take this option. However, he said there may be an opportunity in selling ahead of the deadline because “many hybrids are trading at a premium above $100”.
Perrett also noted the last six to 12 months have seen many new income-type products launched as the market looks to fill the upcoming gap, delivering a greater variety of choice for investors while also driving home the value of professional financial advice as investors look to navigate the shift.
“Although new products provide opportunities for investors,” he said, “they can also create risk for those that do not understand them completely.”
