While Additional Tier 1 capital instruments, commonly known as hybrid bonds, won’t be phased out until March 2032, Schroders fixed income portfolio manager Helen Mason is encouraging investors to start their search for alternatives now, before capital is lost.
“Some investors believe hybrids will remain on issue until then, but that is not the case. Each security will be redeemed at its first call date, ranging from less than a year from now through to 2032,” she said.
“About 76 per cent of current hybrid securities will be called within the next five years. That’s a lot of money that needs a new home,” Mason said.
She said that while major bank hybrids, including Macquarie Bank, are trading with a capital price above par, they will be “called” at par ($100) on the call date.
“Investors will face a capital loss as the call date approaches. This will impact an investor’s total return on bank hybrid holdings,” Mason told InvestorDaily.
Public debt is highly attractive
Mason highlighted public debt as “very” attractive, citing the Australian credit index’s high rating relative to US and European peers.
“Our index is very high quality. The reason for that is partly our highly regulated and high-quality banking system, as well as other high-quality businesses which have highly regulated cash flows but are also inflation linked. We have very low exposure to cyclical companies in our credit market,” she said.
“Furthermore, around 60 per cent of issuance in the Australian public credit universe is unlisted, meaning investors cannot access these companies via equity markets. So, it provides an element of diversification.”
Examples include Sydney Airport, the Port of Brisbane, the Port of Newcastle and Transgrid.
These businesses, Mason said, have high-quality monopoly-like characteristics but need to take on debt to fund projects they are working on.
“The energy transition has meant increased capex for many companies to support the roll-off of traditional energy sources into renewables, which means they have to issue more debt,” she added.
She also pointed to large infrastructure companies that use corporate hybrids to support their capital expenditure (capex) pipeline, a strategy becoming increasingly attractive for wholesale and institutional investors.
Bank hybrids are not as low risk as perceived
Mason warned that bank hybrids are often misunderstood as low-risk instruments due to confidence in Australia’s well-capitalised banking system.
Due to this perception, they have gained popularity among retail investors, which comprise a large percentage of the $40 billion bank hybrid market in Australia.
But according to the portfolio manager, “hybrids are volatile”.
“This view [as a low-risk instrument] stems from confidence in Australia’s highly regulated and well-capitalised banking system. While the probability of a major Australian bank failure may be low, it cannot be ruled out given potential contagion effects from the global banking system.
“Bank hybrids have exhibited far greater price swings than the broader Australian credit market, undermining their reputation as ‘safe income’,” she said.
Originally designed to address liquidity and the contagion shortcomings highlighted by the global financial crisis, hybrids are now being phased out because regulators APRA and ASIC no longer view them as “fit for purpose or a suitable investment for retail investors”.
“Clearly it is time to think about transitioning from those hybrids and looking at other opportunities in the market, and there are some very compelling alternatives.”
