The phase-out of AT1 as eligible bank capital offers an opportunity to explore global fixed income and unlock potentially higher returns and greater diversification, according to a recent PIMCO report.
The fund manager noted that while Australian bank hybrids have long been a staple in portfolios, the Australian Prudential Regulation Authority (APRA) announced in December that AT1 would be phased out as eligible bank capital.
This is expected to see the $40+ billion hybrid market effectively vanish by 2032, said PIMCO.
“Historically, the appeal of hybrids has not been solely due to their credit risk profile or the enticing spreads associated with higher-risk credit. A significant part of their yield advantage came from franking credits,” it said.
PIMCO said that with hybrids facing obsolescence, investors are now forced to look for options to replace this income.
The current environment, it said, offers an opportunity to transition from concentrated corporate credit risks, such as Australian hybrids, to a diversified portfolio spanning domestic and global fixed income markets.
“A simple 50/50 blend of active core bond and multisector credit funds, hedged to AUD, currently yields around 6 per cent,” it said.
“This compares favourably to the expected 5.6 per cent p.a. return for global equities over the next five years, based on PIMCO’s valuation-aware capital market assumptions.”
The fund manager noted that while an analysis of 38 hybrid securities with an average call date in 3.5 years reveals current returns of 7.4 per cent, these yields are expected to decline to around 6.7 per cent over the coming years as cash rates fall.
“Investors should be aware that these hybrids carry elevated credit and tail risks, including the possibility of conversion into equity and substantial losses, even in scenarios where senior bonds recover.”
The fund manager said a diversified portfolio of high-quality fixed income can deliver equity-like returns over the next five years while exhibiting only one-third of the risk associated with equities, based on its analysis.
PIMCO outlined in the report that it had evaluated a broad range of strategies across Australian and global bond markets to identify alternative income sources, including enhanced cash strategies, cord bonds, multisector credit strategies, niche allocations to capital securities and up to 25 per cent exposure to semi-liquid, multi-sector global private credit.
“We then conducted portfolio optimisations based on expected returns relative to tail risk. We capped private credit at 25 per cent of the allocation and set other strategies’ weight between 10 per cent and 40 per cent to enforce meaningful diversification,” it said.
“We compared a hybrid model (with and without franking credits) with two optimal portfolios. The ‘hybrid yield matching’ portfolio, which generates the same 6.7 per cent expected return as the hybrid model, demonstrates that investors can match hybrids’ after-tax returns without franking credits, while reducing tail risk by approximately 20 per cent.”
The fund manager said the lower risk optimal portfolio allows more conservative investors to target a 6 per cent return. This is close to the 6.7 per cent return expected for hybrids and is in line with PIMCO’s expectation for equities but also reduces the tail risk relative to hybrids by more than 50 per cent, it said.
The report also explained that while hybrid investors have often favoured listed vehicles for their liquidity and transparency, the growing availability of active fixed income exchange-traded funds and private credit listed investment trusts offer 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,” PIMCO said.
The phasing out of hybrids it said should be viewed “as a catalyst for investors to explore global fixed income opportunities”.
“When replacing hybrids, we believe that investors can maintain around 75 per cent of their capital in daily liquid vehicles focused on multi-sector credit and core bonds, while allocating up to 25 per cent to semi-liquid diversified private credit to enhance yields,” it said.
“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.”
