Building a better breed of hybrid

The phase-out of bank hybrid securities has begun, and the $43 billion currently invested, needs to be deployed elsewhere. Investors can construct a hybrid of bank debt and equity securities to replace outgoing bank hybrids. However, we think they can do better by taking a diversified, yet active multi-asset approach to investing that emphasises income generation and quality in equities, and duration management in debt.

Hybrids are generally securities that pay floating rate coupons and give investors the option of conversion to the ordinary shares of the issuer at a set date in the future. Investors favouring income-producing assets tend to have an appetite for hybrids, not the least because they offer franking benefits. 

For the banks, most of their hybrid issuance are also known as Additional Tier 1 (AT1) securities, and bank issuance of AT1 hybrids is being phased out by the Australian Prudential Regulatory Authority (APRA). 

As these hybrids mature and new issuance stops, existing holders will need to find suitable replacements. For example, ANZ bank’s Capital 3 notes hit mandatory conversion on March 20, stripping investors of $950 million of their holdings. In mid-April, there are Commonwealth Bank PERLS X Capital Notes that will mature.

It is important to highlight that it is only AT1 bank hybrids that are being phased out by APRA. Insurers will still be able to issue hybrids. Also, bank hybrids do not all mature straight away, and so investors may opt to buy and hold the ones that remain in the market. However, the window to do so is narrowing, and ultimately, there are a lot of income investors that need to re-allocate money out of bank hybrids and into alternatives. $5 billion of hybrid funds require re-deployment in 2025, followed by $4.9 billion in 2026 and $7.5 million in 2027.

The natural alternative is to construct a synthetic hybrid security through a combination of bank equity and bank debt. The equity exposure captures the right of hybrid investors to convert their securities to ordinary stocks. It also captures franking because debt securities apart from hybrids do not offer this. 

On the topic of bank debt, there are various kinds of securities on offer in the wholesale market. These securities are generally not directly accessible to retail investors. The most common bank debt securities are known as Additional Tier 2 (AT2) securities, or so-called “sub-ordinated bank debt”.

Is it possible for hybrid investors to do better than a synthetic of bank equity and debt? We believe so. In the first place, most hybrids are floating rate notes. This means that as interest rates move up and down, the coupons that are paid out on these securities move up and down as well, with a short delay. Therefore, as interest rates fall, the risk is that hybrid coupons also fall. 

Further, there is re-investment risk, because in a lower rate environment, hybrid investors are forced to reinvest into lower yielding options. Investors end up being passive passengers on the rate cycle. Many might be comfortable with this prospect – but those that aren’t ought to take out more fixed rate exposure, which they can do through wholesale debt securities.

Second, a synthetic of bank equity and debt gives investors little sectoral diversification, because they are essentially taking a large position on the health of banks through both sides of the portfolio. We think it is possible to package other, non-bank shares with bank sub-ordinated debt to come up with a better portfolio risk profile.

For context, history suggests that the annualised volatility of a sectorally diverse, high yielding equity portfolio is around 15% - blending this with a debt portfolio skewed largely in favour of financial corporate debt can almost halve this figure.

WAM Income Maximiser is the first listed investment company (LIC) in Australia seeking to address these issues. The benchmark is comprised of 60% equities, and 40% debt. It has multiple asset classes and therefore levers to improve risk management. Importantly, the inclusion of debt in the portfolio gives retail investors access to an asset class they ordinarily would not have access to. 

The equity portfolio is made up of high-quality stocks that either offer high dividend yields today, high dividend yields tomorrow, or capital management opportunities. They may or may not be banks. The debt portfolio is made up of high-quality wholesale debt securities, which in turn, are largely the sub-ordinated debt securities of the major banks given narrow market breadth.

WAM Income Maximiser seeks to deliver a franked dividend yield of at least the Reserve Bank of Australia’s (RBA’s) cash rate plus 250bps. By construction, our model investment portfolio covers most of this hurdle rate using the flow-through dividends and interest received from the underlying securities. 

Further, the model portfolio benchmark of equity and debt offers significantly reduced volatility relative to an equity-only portfolio because it is well diversified. Importantly, WAM Income Maximiser is not a passive vehicle. We seek to actively manage interest rate risks on both the equity and debt sides of the portfolio, so that investors don’t have to.

Find out more about WAM Income Maximiser.

Subscribe to our investment and market insights here.