More headwinds for income investors

Income-focussed investors face more challenges this year post the fall in interest rates, equity yields, and interest in bank hybrids weakens.

The Reserve Bank’s 0.25% rate cut in February potentially signals the start of lower rates for new term deposit holders this year. With the market pricing in another two 0.25% rate cuts by year’s end[i], the trend for term deposit rates is down, although the size and speed of rates cuts could be tempered by persistent higher inflation.

In equities, the average dividend yield on Australian shares has edged lower since 2022 and is now below 4%.[ii] With some large-cap miners cutting their dividend in the latest earnings-reporting season, and some Australian banks reporting earnings below market expectation, the dividend outlook is clouded.

Then there’s bank hybrids. In December 2024, the Australian Prudential Regulation Authority (APRA) announced that the $45-billion bank hybrid market[iii] will be phased out between now and 2032.[iv]

Hybrids have been a mainstay in many retail portfolios over the past decade due to their yield. Several ASX-listed hybrids issued by the big-four banks caught investors’ eyes with a seemingly attractive return for those who live off their portfolio income. But the hybrid market will potentially end.

These are tectonic shifts for income investing. For many income investors, the choice this decade has been unusually narrow: term deposits or bank hybrids, or perhaps Australian bank or large-cap mining shares for their dividends.

Investors should use these changing conditions to consider the amount of risk required to achieve their income goals and whether it is commensurate with potential returns on offer. Also, to look further afield for income opportunities that have the potential to provide a better risk-return trade-off – and beware of investments that do not.

Hybrid complexities

Like their name suggests, hybrids combine aspects of debt securities (bonds) and equity securities (shares). Like a bond, hybrids promise to pay a fixed or floating rate of return until a reasonably certain date.

But hybrids, due to their equity-like features, have higher risk than traditional bonds. Unlike secured bonds backed by collateral, hybrids are unsecured, meaning they depend on an issuer’s finance strength and promise to pay.

Hybrids rank below senior subordinate bonds in a bank’s capital structure. They can also be converted into shares (potentially at the worst possible time) or completely written off if a bank is in financial distress.

Recognising these risks, APRA is phasing out the use of Additional Tier 1 (AT1) hybrids, laying out a framework for their withdrawal over the next eight years.

In announcing the change, APRA said in a statement[v]: “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.”

Judging by growth in the bank hybrid market over the past decade, arguably investors may not sufficiently recognise credit and liquidity risks with hybrids, or the insufficient return provided by these securities relative to their risk.

Our view is that the potential downside risk of bank hybrids is not commensurate with their potential upside return – an asymmetrical risk-return trade-off. Simply, hybrids have equity-like risks without the potential for equity-like returns.

Liquidity risk is a further consideration. Hybrids are typically less liquid than ordinary shares and some hybrids can potentially take time to exit at a stable market price. It is too soon to know how APRA’s change will affect hybrid-market liquidity, but it is an issue that hybrid holders should consider sooner rather than later

Franking is another complication. Most hybrid coupons include franking credits that must be claimed back in an investor’s tax return, creating additional tax work, otherwise the cash yield is much lower than the headline yield.

Conclusion

While we are not in the business of forecasting interest rates, equity yields or future liquidity in bank hybrids, we are confident that the main sources of yield for income-focussed investors face growing challenges this year.

Also, that retail investors should consider looking further afield for income opportunities, beyond a previously narrow set of choices.

Income managed funds that can deliver higher returns than term deposits and competitive returns with bank hybrids – at relatively lower risk – could help income investors maintain their purchasing power and preserve their capital, amid heightened market and geopolitical volatility this year.