Regulatory changes in Australia, including the proposed phasing out of listed bank hybrids for retail investors, have opened opportunities for investors in local bonds. With stable credit fundamentals and attractive income yields, Australian bonds stand out as a compelling option for investors seeking a balanced portfolio compared to US bonds, which face more risk from rising inflation.
Funding Trump’s policies will require more US government bonds to be issued, which could lower bond prices further and raise yields given the additional supply.
In contrast, Australian bonds are offering fixed returns of 6 per cent to 7 per cent, translating to real returns of 3 per cent to 4 per cent after inflation. This, coupled with a positive inflation trajectory in Australia, creates a strong investment case for bonds. Australian credit fundamentals are relatively better than the US, given higher average credit ratings and more favourable credit metrics.
Diversify across bonds to benefit
We recommend investors consider balancing a portfolio of fixed and floating rate bonds. A balanced portfolio strategy that combines fixed and floating rate bonds is key to navigating the year ahead and benefiting from interest rates eventually falling in Australia.
Given the interest rate outlook and the upward sloping slope, we think there is merit in locking in longer duration and exploring 7-to-10-year tenors due to attractive levels on an outright yield basis. From a credit spread point of view, we think the mid-part (three to five years) of the curve provides the best relative value given credit spreads are broadly flat in the five-year+ part of the curve.
High-quality investment grade bonds, such as major bank Tier 2 bonds, are a cornerstone of a solid investment portfolio. These bonds provide reliable returns and strong performance for potential for investors.
Government bonds may become more attractive as interest rates potentially decrease. Although currently underweight in many portfolios, especially retail portfolios, Australian government 10-year bond yields may edge lower over the next 24 months, potentially offering bond price appreciation. We believe that the Australian cash rate will reach 3.6 per cent by the end of 2025 (effectively three rate cuts across the year) and that the Australian 10-year bond yield will be sitting at c.4 per cent (around 0.5 per cent lower than current levels). Given expected price appreciation, investors would benefit from incorporating government bonds and residential mortgage-backed securities into a diversified portfolio, which can enhance risk management.
In terms of floating rate notes, these provide an effective hedge against rates remaining elevated and an allocation of 50 per cent would be ideal in the current environment. Investors could then pivot towards fixed-rate bonds once the rate-cutting cycle starts in Australia or they could pivot now to benefit from any fall in government bond yields and rising prices once official rates are cut by the Reserve Bank.
Hybrid ban may accelerate shift to bonds
We are also likely to see a shift towards bonds and other fixed income instruments as bank hybrids are phased out in Australia. The banking regulator, APRA, is phasing out AT1 capital instruments, often called hybrids, and it has asked banks to replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of financial stress.
The proposed changes follow last year’s global banking turmoil where several US and European banks either failed or needed to be resolved in short succession, with several governments having to intervene to minimise the risk of contagion and financial system instability.
APRA has proposed starting the transition to a simpler bank capital framework from 1 January 2027, with all current hybrid bonds on issue expected to be replaced by 2032. For existing investors, APRA does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.
Either way, APRA’s decision will create a significant shift in the investment landscape, particularly for retail investors who hold a large portion of the $40-billion-plus hybrid market. Hybrids sit at the bottom of a bank’s debt capital stack and just above common equity. They have characteristics of debt and equity, in that they pay investors a set level of income, though they rank below bondholders and depositors in the event of a bank’s collapse.
With banks paying 30 per cent corporate tax, hybrids were an effective way of monetising the franking balance that doesn’t get paid out as dividends. The removal of hybrid bonds from the capital structure of banks reduces the income generating assets available to retail and retirement investors. We are likely to see self-managed super funds replace hybrids with ASX listed Tier 2 or corporate bonds going forward.
Fixed income exchange-traded funds are a popular way to gain access to bonds. They are popular with advisers and are likely to become more so following proposed regulatory changes to hybrid securities as we anticipate greater retail demand for fixed income assets to replace the income that hybrids have offered.
Matthew Macreadie, executive director, head of credit strategy and portfolio management, Income Asset Management
