Where to look in fixed income to replace AT1s

With AT1s being phased out, what alternatives can advisers use to replace these assets and the income they provide?

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 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. 

Ahead of the phasing out, PIMCO said similar risk-adjusted returns can typically be achieved via assets such as multi-sector credit, private credit or BBB-rated credit.

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The fund manager suggested investors should take a two-pronged approach with 75 per cent of their capital in daily liquid vehicles focused on multisector credit and core bonds, and 25 per cent in semi-liquid diversified private credit to enhance yields. 

“A diversified approach that extends beyond corporate credit risk to include additional risk factors such as interest rates, yield curve exposures, and securitised credit can deliver a superior risk-return profile compared to Australian hybrids.”

In terms of portfolio construction, Praemium said advisers could hold their existing hybrids to maturity, but should avoid delaying for too long in case there are minimal chances to transition into other assets before liquidity tightens and to avoid forced sales at unfavourable prices.

Praemium suggested alternatives such as Tier 2 bonds, private credit or unlisted income funds. 

“Investors have time to prepare but should begin reviewing income strategies and identifying new opportunities for stable, tax-aware yield. Whether that means holding existing hybrids to maturity or gradually reallocating into emerging income strategies, the key is to act deliberately, not reactively.”

PIMCO also noted looking at listed solutions was another attractive way, such as active fixed income ETFs and private credit listed investment trusts (LITs). 

PIMCO said: “Hybrid investors often favour listed vehicles for their liquidity and transparency. The growing availability of active fixed income ETFs and private credit listed investment trusts (LITs) now offers accessible, liquid options that allow investors to transition smoothly from hybrids while maintaining diversified exposure. 

“Such listed products provide a practical way to implement these proposed portfolio solutions without compromising ease of trading or portfolio flexibility.”

There has been strong growth in the fixed income space, and State Street has flagged global active fixed income ETF assets under management could reach US$700 billion by year-end 2026, driven by non-US markets. 

Meanwhile, JP Morgan Asset Management (JPMAM) believes active fixed income ETFs will “grow a lot more” in the coming years.

“One of the areas we are seeing particular interest from institutional investors is in fixed income which is traditionally an active asset class that can be difficult to access. They don’t always trade on a daily basis, so ETFs offered via the secondary market offer an extra layer of liquidity and that’s an additional benefit. That will be an area of growth going forward,” said JPMAM’s global head of ETFs Travis Spence.