Listed hybrids likely to trade tighter

Hybrid margins have tightened significantly since the Australian Prudential Regulation Authority (APRA) first signalled that bank hybrids would be phased out by 2032. The official confirmation in December 2024 removed a major uncertainty—whether discretionary call dates would be exercised. Now, it is expected that APRA will prefer banks to redeem each hybrid at its first call date.

As a result, the risk gap between hybrids and traditional bonds is narrowing. If investors believe the probability of missed distributions or non-viability/capital trigger events are low, hybrids could trade closer to more senior bonds. Given the strength of the Australian banking sector, even the issue of subordination may be seen as largely theoretical—relevant only in the event of a bank failure.

Whenever I present this view, a common question arises: could hybrids trade inside Subordinated Notes (Tier 2 capital issues) on their way to margins closer to senior bonds? The answer is theoretically yes, but practically no.

Why Tier 2 Capital Calls Are Different

Subordinated Notes carry a strong economic incentive for issuers to redeem them at the first opportunity. This is because APRA applies a progressive amortisation (discounting) to Tier 2 capital instruments starting five years before maturity to encourage timely refinancing. Consequently, any certainty in call for hybrids is to some degree mirrored in Tier 2 issues.

How Tier 2 Amortisation Works:

• Starting five years before maturity, APRA discounts the recognised amount of the Tier 2 instrument in regulatory capital by 20% per year.
• By the final year, only 20% of its original value counts towards the bank’s regulatory capital.
• By maturity, it is fully amortised and no longer contributes to capital adequacy.

This structure means banks are highly motivated to call Tier 2 instruments at the first opportunity, and the market prices them accordingly.

As Tier 2 bonds follow a predictable call pattern, their margins may also tighten as hybrid margins compress. However, whether Tier 2 margins remain consistently inside Australian bank hybrid margins will depend on multiple factors, including supply dynamics. APRA expects most bank hybrid issuance to be offset by Tier 2 issuance over the next seven years, leading to the final call of the last bank hybrid by 2032. This will mean many billions of additional subordinated bond issuance and potentially some widening margin pressure for new issues if demand growth doesn’t match supply growth.

Market Implications

Given the above factors, listed bank hybrids could be trading at tighter margins than they currently are. For example:

• AN3PK, a hybrid with a 5-year term to call (March 20, 2030), is currently trading at a 209-basis-point margin.
• A newly issued 5-year ANZ senior bond would price at approximately 82 basis points.
• This results in a 127-basis-point spread, indicating that the market still perceives bank hybrids as significantly riskier than bank senior bonds.

However, as hybrids continue to be called as expected, this spread could narrow considerably over time – and they will, like clockwork, be called on their first call date (unless APRA reverses its decision).

Investment Opportunity

For investors comfortable with the limited risk of non-payment or a non-viability/capital trigger event, current hybrid margins offer an attractive opportunity. Despite a diminishing risk premium, hybrids still yield significantly more than senior bonds. As confidence in APRA’s regulatory direction strengthens, and as call patterns are reaffirmed, hybrids should continue to reprice tighter—rewarding those who position early.

However, investors must carefully consider distribution accrual values and call dates. Since hybrids trading at tighter margins will be priced well above their $100 face value, timing the exit will be crucial. Additionally, trading liquidity may become an issue as the hybrid market shrinks and active investor participation declines. Risk of bank default still needs to be assessed by any prospective investor.

Another key factor is broader market stability. While the trend towards tighter hybrid margins should continue under normal conditions, significant volatility events could temporarily disrupt this trajectory. Investors should remain aware of external market risks that may reset pricing across the capital structure.