Matthew Macreadie

As the Australian Prudential Regulation Authority (APRA) plans to phase out Australia’s $43 billion hybrids market over the next seven years, investment-grade credit and corporate bonds provide an attractive and stable income stream, according to Matthew Macreadie, executive director of credit strategy and portfolio management at Income Asset Management (IAM).

“With hybrids gradually disappearing from the market, investors who rely on them for income certainty must adapt, and increasingly they are seeking reliable alternatives,” Mr Macreadie says.

“Corporate bonds, particularly investment-grade credit, offer an excellent alternative, offering yields between 6 per cent to 7 per cent per annum, ensuring continued access to predictable returns while maintaining a strong credit profile.

“As hybrids are phased out, there’s a clear gap for income investors seeking simpler and more effective forms of capital,” he says.

Mr Macreadie anticipates that demand for investment-grade bonds will surge as more investors seek safe, predictable income streams, against the background of greater market volatility and the phasing out of hybrids, which have long been favoured by retail investors due to their high-yield characteristics.

“With more reliable alternatives now available, corporate bonds, especially those with strong credit ratings, are a good way to continue earning consistent returns while reducing risk exposure,” Mr Macreadie says.

“These bonds not only offer income but also provide a solid investment-grade buffer, making them a stable choice for conservative investors who once turned to hybrids for yield.

“By reallocating into corporate bonds, investors can improve portfolio diversification and mitigate the risks tied to the winding down of hybrids.

“Corporate bonds represent a prime opportunity for investors to still access predictable income with minimal risk of capital loss,” Mr Macreadie says.

“IAM recently launched two Single Bond ETFs to fill this gap, offering investors access to a single underlying asset and providing exposure to interest payments and capital preservation, and are seeing strong inflows off the back of its launch.

“These new strategies are catering to the growing appetite from Australian investors for fixed income products that have lower volatility than equities and a greater level of income than cash and term deposits. This allows investors to easily access fixed income solutions and transition seamlessly from hybrids to more traditional forms of credit investment.

“We expect more products to come to market in 2025, as the demand for credit products is expected to rise given greater volatility in equity markets. Credit returns are less subject to variability and uncertainty compared to equities. With share markets down this year, bonds could do better, especially if we see a slowing in economic growth and interest rates fall even further in 2025 or 2026.”

The Australian share market has dropped around 2.7 per cent over the year to 24 March. In the US, equity markets have also dropped, led by technology shares, with the Nasdaq Composite Index down around 5.8 per cent over the year to date, and the S&P 500 down 2.0 per cent.

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Matthew Macreadie

The banking regulator’s announcement that it plans to phase out bank hybrid securities over the next seven years could see the price of hybrids rise as they become scarcer and see an increase in the value of bank shares as investors price in a possible rise in dividends as banks seek to utilise available franking credits according to IAM’s Matthew Macreadie, the executive director of credit strategy and portfolio management at Income Asset Management.

APRA is proposing that banks phase out the use of AT1 capital instruments, often called hybrid bonds or simply hybrids, and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of financial stress.  Any moves could impact retail investors, who hold more than 50 per cent of hybrids on issue.

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.

APRA recently said^[1] it has three options: maintaining the status quo, redesigning bank hybrids to make them operate more effectively, or replacing hybrids with other existing, more reliable forms of capital.

According to IAM’s Matthew Macreadie, if hybrid bonds are replaced, this could potentially boost the value of hybrids bonds held by investors as they become scarcer.  “This is a result of APRA effectively removing hybrids as an asset class for investors from 1 January 2027,” he said.

“Bank share prices may factor in higher franking credits being attached to future dividends as a result of the removal of hybrids as an asset class. This could see the gross dividend yield on a major bank share increase from the current 6 per cent to 7 per cent level.

“Existing hybrid bonds held by investors such as SMSFs should provide good, regular income up until their call dates when they are redeemed. The door hasn’t closed on capital instruments being in the hands of retail investors in the future. Thus, a bank could issue ASX-listed Tier 2 with franking credits attached to meet the needs of SMSF investors,” he said.

“With banks paying 30 per cent corporate tax, hybrids were a nice way of monetising the franking balance that doesn’t get paid out as dividends.  Thus, investors such as SMSFs may look to replace hybrids with ASX listed Tier 2 going forward,” Mr Macreadie said.

The removal of hybrid bonds from the capital structure of banks reduces the income generating assets available to retail investors.  IAM is currently developing products that will allow individual investors seeking income certainty access to the broader fixed income market. Hybrid instruments issued by other sectors such as insurance are not part of the reform.  These assets will also likely see a lift in demand from investors seeking income.

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.

“The purpose of hybrids is to absorb losses in the instance of a crisis. Unfortunately, events last year highlighted that hybrids did not fulfil this function in a crisis situation due to their complexity and the risk of causing contagion. These risks are greater in Australia due to the high proportion of hybrid securities held by retail investors,” he said.

APRA’s announcement follows an extensive consultation process that began with the release of a discussion paper^[2] last year asking for feedback from the financial services industry on a range of ideas to improve the effectiveness of hybrid instruments for use in a potential bank stress scenario. APRA received feedback from 26 submissions and more than 40 engagements.

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 said it does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.

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Notes:
[1] https://www.apra.gov.au/news-and-publications/apra-proposes-update-to-bank-capital-framework-to-strengthen-crisis
[2] https://apra.us19.list-manage.com/

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Matthew Macreadie

Key points

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Mr Macreadie is recommending investors buy Australian Tier 2 bank and insurance bonds.

“2024 promises to be a year of clear winners and losers where security selection will be rewarded. We expect to see some high yield defaults impact the market, but overall, the investment-grade credit market is likely to gain in strength,” Mr Macreadie says.

“With inflation falling from its multi-decade highs, and the prospect of modest rate cuts in the second half of 2024, we should see longer duration, high quality bonds perform well and gain in value. Beyond 2024, interest rates could fall further as central banks, having likely tamed inflation, reduce interest rates to protect employment and economic growth, supporting the environment for bonds,” he says.

With bond yields at their highest levels for several decades, Mr Macreadie also believes Australian investment grade bonds could outperform against US bonds and provide a good buffer against any potential credit spread widening.

“Australian credit spreads usually follow credit spreads in the US, but we believe they could outperform in a recessionary scenario. That’s because Australia’s real economic growth supports the credit environment and Australian investment-grade credit has historical default rates close to zero.

“In addition, Australian superannuation funds have been increasing their exposure to fixed income – and Australian BBB investment-grade credit spreads are wider than equivalent US investment-grade credit spreads – so we are confident of the potential for the outperformance of high-grade Australian corporate bonds,” he says.

Within the Australian investment grade credit market, IAM believes some sectors could outperform. Tier 2 bank and insurance bonds, for example, are offering “outsized risk-adjusted returns”.

“Australian banks are well positioned for any downside in the economic outlook. They are well capitalised, with very high Common Equity Tier 1 capital ratios. The most positive development has been that Australian mortgage delinquencies have not really risen significantly despite central bank tightening,” he says.

“Residential mortgage-backed securities (RMBS) are also favoured, given credit spreads effectively doubled in 2022 and are only now starting to normalise across senior and mezzanine tranches. From our perspective, buying AA-BBB rated RMBS tranches at yields of 7 per cent to 9 per cent with strong collateral protection remains very attractive,” he said.

“We are constructive on most sectors within the Australian corporate market such as infrastructure, utilities, retail and mining, especially as issuance will remain muted in 2024. Additionally, Australian companies are running net leverage and interest coverage ratios in line with historical averages and have the capacity to absorb an economic shock.”

Mr Macreadie also sees healthily outcomes for private credit, which historically offered an illiquidity premium over the public bond market. In the higher yield environment, investors are looking at the merits of private credit as an alternative to equity given attractive yields.

“With current yields of around 5 per cent to 7 per cent in investment-grade credit, and 6.5 per cent  to 10 per cent for sub-investment-grade credit, complemented by high-certainty cash yield and capital seniority, we expect strong investment demand for private credit in 2024,” says Mr Macreadie.

One sector, however, that IAM is cautious on is A-REIT bonds. “We view significant potential for volatility during 2024 as the devaluation cycle plays out for office and retail sectors, so we could see rising vacancies compress values.”

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