The hybrid phase-out opens the door to optimised global fixed income portfolios offering competitive returns with lower risk.

Key takeaways

• Expanding beyond domestic hybrids to a global fixed income opportunity set can unlock better returns and greater diversification.
• To match the expected return from hybrids, only 25% of existing hybrid exposures need to be allocated to illiquid strategies such as private credit, with the balance invested in daily liquid bond solutions.
• A diversified approach that incorporates interest rate, yield curve, and securitised credit risks—rather than focusing solely on corporate credit—can offer a superior risk-return profile compared with Australian hybrids.

Australian bank hybrids, also known as Additional Tier 1 (AT1) capital, have long been a staple in the portfolios of Australian investors. However, the Australian Prudential Regulation Authority (APRA) announced in December 2024 the phase-out of AT1 as eligible bank capital, a move that will see the $40+ billion hybrid market effectively vanish by 2032. This impending change leaves investors facing the pressing challenge of finding suitable alternatives to replace the attractive yields and income that hybrids have traditionally provided.

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. As hybrids face obsolescence, investors must ask: what can effectively replace this income?

Transitioning to a global fixed income opportunity set as hybrids phase out

An analysis of 38 hybrid securities with an average call date in 3.5 years reveals current returns of 7.4%. However, these yields are expected to decline to around 6.7% over the next three to five 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.

As outlined in  “The “Magnificent 7” Reasons Why Now is a Good Time to Invest in Core Bonds”^[1], we believe that today’s environment presents an opportune moment to transition from concentrated corporate credit risk, 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%.^[2] This compares favourably to the expected 5.6% p.a. return for global equities over the next five years, based on PIMCO’s valuation-aware capital market assumptions.

In essence, we believe that 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.^[3]

Optimising bond portfolios for income and risk appetite

We evaluated a broad range of strategies across Australian and global bond markets to identify alternative income sources, including:

• enhanced cash strategies, which aim to outperform the RBA cash rate by around 1% p.a. with low risk
• core bonds that incorporate interest rate exposure
• multisector credit strategies spanning investment grade, high yield, emerging market debt, and global securitised credit
• niche allocations to capital securities (global equivalents of Australian hybrids), and
• up to 25% exposure to semi-liquid, multi-sector global private credit, which allows for quarterly redemptions and offers greater diversification than corporate direct lending.

We then conducted portfolio optimisations based on expected returns relative to tail risk^[4]. We capped private credit at 25% of the allocation and set other strategies’ weight between 10% and 40% to enforce meaningful diversification. (For more on expected returns and risk factors, see Appendix).

We compared a hybrid model (with and without franking credits) with two optimal portfolios (see Figure 1). The “hybrid yield matching” portfolio, which generates the same 6.7% 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%.

The “lower risk” optimal portfolio allows more conservative investors to target a 6% return – close to the 6.7% return expected for hybrids and in line with our expectation for equities – while reducing their tail risk relative to hybrids by more than 50%.

Examining the composition of the two optimal portfolios

Figure 2 shows the allocation and summary statistics for the two optimal portfolios targeting 6.0% and 6.7% returns, respectively. Daily liquid core bonds and multisector credit constitute the majority of both portfolios. The “lower risk” portfolio allocates a greater proportion to enhanced cash and slightly less to private credit. Both portfolios maintain modest interest rate risk, with durations around three years, half that of the Bloomberg Global Aggregate Index, the flagship benchmark for global bonds.

These portfolios are diversified not only across asset classes, but also across risk factors. The “lower risk” portfolio, for example, sources around 40% of its risk from corporate debt, 20% from asset-based credit, and 25% from global interest rate exposure.

Hybrid investors often favour listed vehicles for their liquidity and transparency. The growing availability of active fixed income ETFs and private credit listed investment trusts (LITs) now 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.

Diversify beyond hybrids to secure equity-like expected returns in global fixed income

The phasing out of hybrids 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% of their capital in daily liquid vehicles focused on multisector credit and core bonds, while allocating up to 25% to semi-liquid diversified private credit to enhance yields.

A diversified approach that extends beyond corporate credit risk to include additional risk factors such as interest rates, yield curve exposures, and securitized credit can deliver a superior risk-return profile compared to Australian hybrids.

Today’s high yields combined with attractive valuations across (predominantly non-corporate) credit markets provide an opportunity to lock in equity-like expected returns in high quality fixed income. This enables investors to de-risk portfolios without sacrificing returns, while enhancing diversification in equity-dominated portfolios.

Appendix

Understanding the risk-return profile of Australian bank hybrids

Hybrid securities carry greater credit risk than typical corporate bonds due to their subordinated status on the balance sheet. They also carry tail risk, including potential conversion to equity and material capital losses, even in scenarios where senior bondholders might recover their investments during severe crises.

By comparing the credit spread of hybrids relative to BBB-rated corporate debt with similar maturities, we estimate the credit risk premium in hybrids to be 75% higher. This risk premium difference serves as the key input for estimating risk in hybrids.^[4]

Additionally, the Australian hybrid securities market is more concentrated than diversified credit markets, with the top five issuers accounting for the majority of outstanding debt. We factor in this lack of diversification by attributing a 0.7% volatility contribution from idiosyncratic risk.

Expected returns and risk factors in global fixed income markets

As Figure 3 shows, expected returns across income sources range from 4% to 9% p.a. When considering the franking credit advantage of hybrid securities, their risk-adjusted returns are in line with diversified multisector credit, private credit, and Australian BBB-rated credit.

The risk profiles of these strategies vary significantly in magnitude and composition, offering diversification benefits at the portfolio level – unlike hybrids, which are predominantly driven by corporate credit risk.

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Notes:
[1] https://www.pimco.com/au/en/insights/the-magnificent-7-reasons-why-now-is-a-good-time-to-invest-in-core-bonds
[2] As of 30 April 2025. Yield tends to be a good predictor of future returns as the correlation between YTM and 5-year future total returns of the Bloomberg US Aggregate Index is 94% based on data from 1976 to 2025
[3] Based on valuations as of 31 March 2025 (US Aggregate Bond Index yield > 5% and the cyclically adjusted price-to-earnings ratio for the S&P 500 >30, future 5-year median returns are 7.8% p.a. for bonds and -0.8% for equities). This analysis uses data from January 1973 to the date of publication.
[4] We find tail risk to be a more valuable measure of risk, particularly for credit investments that tend to exhibit more left tail events than a normal distribution suggests. Specifically, we use the Conditional Value at Risk over a one-year horizon with 95% confidence as our tail risk measures. It estimates the worst annual return over a 20-year horizon.
[5] We follow a duration x spread approach and multiply the credit spread duration of 3.56 years in the AusBond Credit BBB 3-5 Years by ~1.75 to estimate the sensitivity of hybrid securities to Australian BBB spread levels.

Disclosures
IMPORTANT INFORMATION
All source citations are PIMCO unless stated otherwise. The information in this article is for general information only and has been prepared without taking into account the objectives, financial situation or needs of investors. Before making an investment decision investors should obtain professional advice and consider whether the information contained herein is appropriate having regard to their objectives, financial situation and needs. Investing in the bond market is subject to risks, including market, interest rate, issuer, credit, inflation risk, and liquidity risk. The value of most bonds and bond strategies are impacted by changes in interest rates. Bonds and bond strategies with longer durations tend to be more sensitive and volatile than those with shorter durations; bond prices generally fall as interest rates rise, and the current low interest rate environment increases this risk. Current reductions in bond counterparty capacity may contribute to decreased market liquidity and increased price volatility. Bond investments may be worth more or less than the original cost when redeemed. Commodities contain heightened risk, including market, political, regulatory and natural conditions, and may not be suitable for all investors. Currency rates may fluctuate significantly over short periods of time and may reduce the returns of a portfolio. Derivatives may involve certain costs and risks, such as liquidity, interest rate, market, credit, management and the risk that a position could not be closed when most advantageous. Investing in derivatives could lose more than the amount invested. Equities may decline in value due to both real and perceived general market, economic and industry conditions. Investing in foreign-denominated and/or -domiciled securities may involve heightened risk due to currency fluctuations, and economic and political risks, which may be enhanced in emerging markets. Sovereign securities are generally backed by the issuing government. Obligations of US government agencies and authorities are supported by varying degrees, but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. High yield, lower-rated securities involve greater risk than higher-rated securities; portfolios that invest in them may be subject to greater levels of credit and liquidity risk than portfolios that do not. Mortgage- and asset-backed securities may be sensitive to changes in interest rates, subject to early repayment risk, and while generally supported by a government, government-agency or private guarantor, there is no assurance that the guarantor will meet its obligations. Income from municipal bonds may be subject to state and local taxes and at times the alternative minimum tax. Swaps are a type of derivative; swaps are increasingly subject to central clearing and exchange-trading. Swaps that are not centrally cleared and exchange-traded may be less liquid than exchange-traded instruments. Inflation-linked bonds (ILBs) issued by a government are fixed income securities whose principal value is periodically adjusted according to the rate of inflation; ILBs decline in value when real interest rates rise. Treasury Inflation-Protected Securities (TIPS) are ILBs issued by the US government. Certain US government securities are backed by the full faith of the government. Obligations of US government agencies and authorities are supported by varying degrees but are generally not backed by the full faith of the US government. Portfolios that invest in such securities are not guaranteed and will fluctuate in value. This material contains the opinions of the manager and such opinions are subject to change without notice. This material has been distributed for informational purposes only and should not be considered as investment advice or a recommendation of any particular security, strategy or investment product. Information contained herein has been obtained from sources believed to be reliable, but not guaranteed. Forecasts, estimates and certain information contained herein are based upon proprietary research and should not be interpreted as investment advice, as an offer or solicitation, nor as the purchase or sale of any financial instrument. Forecasts and estimates have certain inherent limitations, and unlike an actual performance record, do not reflect actual trading, liquidity constraints, fees, and/or other costs. In addition, references to future results should not be construed as an estimate or promise of results that a client portfolio may achieve. There is no guarantee that these investment strategies will work under all market conditions and each investor should evaluate their ability to invest for a long-term especially during periods of downturn in the market. No representation is being made that any account, product, or strategy will or is likely to achieve profits, losses, or results similar to those shown. Charts and data have been provided for illustrative purposes and are not indicative of the past or future performance of any PIMCO product. Charts may not be to scale and users should take this into consideration when conducting analysis. This publication contains general information only and has been prepared without taking into account the objectives, financial situation or needs of investors. Because of this, before acting on any information in this publication investors should obtain professional advice (including, if applicable, from a financial adviser) and consider whether the information is appropriate having regard to their objectives, financial situation and needs. Past performance is not a reliable indicator of future results This publication is issued by PIMCO Australia Pty Ltd ABN 54 084 280 508, AFSL 246 862. This publication may include economic and market commentaries based on proprietary research, which are for general information only. Investment management products and services offered by PIMCO Australia Management Limited ABN 37 611 709 507, AFSL 487 505 of which PIMCO Australia Pty Ltd is the investment manager (together PIMCO Australia) are offered only to persons within Australia and are not available to persons where provision of such products or services is unlawful or unauthorised.PIMCO Australia believes the information contained in this publication to be reliable, however its accuracy, reliability or completeness is not guaranteed. Any opinions, estimates or forecasts reflect the judgment and assumptions of PIMCO Australia on the basis of information at the date of publication and may later change without notice. No representation, assurance, or guarantee is given that any opinions, estimates or forecasts will materialise, or investments will provide any level of returns.  This publication should not be taken as a recommendation of any particular security, strategy or investment product. All investments carry risk and may lose some or all of its value. To the maximum extent permitted by law, PIMCO Australia and each of their directors, employees, agents, representatives and advisers disclaim all liability to any person for any loss arising, directly or indirectly, from the information in this publication. No part of this publication may be reproduced in any form, or referred to in any other publication, without express written permission of PIMCO Australia. PIMCO is a trademark of Allianz Asset Management of America LLC in the United States and throughout the world. To the extent this publication includes references to Pacific Investment Management Co LLC (PIMCO LLC) and/or any information regarding funds issued by PIMCO LLC and/or its associates, such references are to PIMCO LLC (and/or it associates, as the context requires) as the investment manager of the fund, and not as the issuer of the fund. PIMCO LLC is exempt from the requirement to hold an Australian financial services licence under the Corporations Act 2001. PIMCO LLC is regulated by the Securities and Exchange Commission under US law, which differ from Australian law. PIMCO LLC is only authorised to provide financial services to wholesale clients in Australia.

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Robert Mead

It was way back in May 2013 when PIMCO first uttered the phrase “The New Neutral” in relation to Australia’s cash rate. At that time, we estimated the “New Neutral” rate for Australia to be about 3%. We stand by that view.

Today, over 4 years later, the RBA explicitly referenced 3.5% as their estimate of the neutral nominal cash rate, while also acknowledging significant uncertainty around this estimate.

The clear takeaway from both of these estimates of neutral rates is that versus the pre-Global Financial Crisis (“GFC”) period, we should expect interest rates to be significantly lower than historical cycles.

Additionally, we also know that Australian households have binged on debt since the GFC, taking advantage of lower and lower mortgage rates. More recently, borrowing rates have started to increase for certain borrower cohorts due to regulatory changes designed to limit the potential for systemic risk.

From PIMCO’s proprietary studies, we know that Australian borrower confidence is dominated by two factors: first, the level of borrowing rates; and second, recent changes in house prices. Given the latest housing and interest rate data, it appears we may be approaching an important inflection point, which will limit the flexibility for increases in policy rates.

Given these dynamics, the start of any hiking cycle in Australia will not be possible for at least 6 to 12 months, so it is important to consider the likely global economic dynamics expected to be in place at that time. The Chinese Party Congress will have been concluded before the end of 2017 and in PIMCO’s view there is a high probability of additional economic growth volatility. Also, the level of the Australia Dollar will be key. The RBA reminds us that the depreciation of the Australian dollar since 2013 has assisted Australia’s economic transition which is true, however it is also important to note that the Australian dollar has appreciated by over 15% since early 2016.

Investment Implications: When considering any investment, the expected destination valuation is very important, but even more important is the path and the time required to reach the destination valuation. When it comes to Australian interest rates, we believe the hurdle for RBA action (either higher or lower policy rates) remains high and just like the Federal Reserve, when the time eventually comes to neutralise policy, the path towards the “New Neutral” will be a slow and measured one.

By Robert Mead, Managing Director and Co-head of Asia-Pacific Portfolio Management

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Robert Mead

After 25 years of steady economic growth, Australia is on the verge of wresting bragging rights from the Netherlands for the longest period on record without a recession. While this historic event should be celebrated, the future may not be as rosy.

PIMCO’s base case calls for Australia to keep growing moderately over the next three to five years, in a range of 2% to 3%, with inflation well contained in the 1.5% to 2.5% range. On a positive note, Australia’s sovereign balance sheet is relatively healthy, and its credit rating was just affirmed at ‘AAA’ last month by Standard & Poor’s. But if there is any hint of a downturn in developed markets, or if China migrates toward a worse-than-expected outcome, the resilience of the Australian economy over the next three to five years will be extremely challenged.

Mining and housing: past their prime

Australia’s GDP growth has averaged 2.6% since the end of the global financial crisis, and during this time, the two most important marginal contributors have been mining and housing. Australia produces some of the highest-quality and lowest-cost ore and remains a reliable and competitive energy exporter; however, the demand for these exports would suffer under a weak China scenario, given that Asia represents almost 50% of Australia’s export volumes. As for the housing sector, Australian households are already highly leveraged and major city property prices are elevated, so room for housing to add significantly to the economy would be limited in a period of global weakness.

Australia’s economic growth since the financial crisis has also been supported by other important factors: first, steady growth in the U.S. economy, which is in the midst of its third-longest recovery on record; second, China’s uninterrupted growth, which has been driven by an increase in the national debt level from 161% to 258% of GDP; third, Reserve Bank of Australia (RBA) rate cuts from 7.25% to 1.5%, which have kept the economic engine ticking; and finally, Australian households, which have increased debt to well over 100% of GDP even as household debt in other developed nations has decreased. It follows that any changes to this supportive environment could have ramifications for Australia’s economy.

Policy and interest rate outlook

Rising household debt and property prices in major Australian cities have created a high hurdle for the RBA to move the policy rate from its current record low of 1.5%. With Sydney now the second-most unaffordable housing market in the world (according to Demographia), the RBA would not want to be blamed for inflating housing bubbles with a rate cut. On the flip side, the relatively tepid state of the domestic economy should ensure that any RBA rate hikes are delayed at least until well into 2018.

If the Federal Reserve continues on its path of raising interest rates in the U.S. as expected, then for the first time in more than 15 years we may see the U.S. fed funds rate and the RBA policy rate reach the same level. As we move into 2018, there is a strong likelihood that the RBA cash rate will actually be below the fed funds rate.

Investment implications

The likely crossover of Australian and U.S. policy rates also has implications for investors: Expected returns from hedging U.S. dollar investments back to Australian dollars, which have provided a boost to many portfolios in recent years, will likely fade. In this environment of interest rate convergence, we expect Australian bonds will continue to provide a robust diversification anchor in balanced portfolios.

For more on our long-term views on the global economy, read PIMCO’s 2017 Secular Outlook, “Pivot Points.”

By Robert Mead, co-head of Asia portfolio management in Sydney.

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Bonds continue to perform well.

As we close the books on another Australian financial year, we make a striking observation: Over the last eight financial years, bond returns have exceeded equity returns on average by over 250 basis points per annum.[1]

Over this time, bonds also achieved this performance with almost one-fifth of the volatility of equities and have continued to demonstrate strong diversification benefits.

Yet Australian investors continue to have one of the lowest allocations to bonds in the world. According to the Willis Towers Watson Global Pension Assets Study 2016, the average Australian pension portfolio allocated only 14% to bonds, well below other developed market counterparts like the U.S. (23%), the UK (37%), Canada (31%) and Japan (57%).

Since the global financial crisis, the number of Australians age 65 and over has increased by more than 750,000, a rise of 27% in just seven years.[2] With this dramatic shift in demographics comes an important need for retirement income; given the investment horizon is shorter, retirement income sources should generally obtain exposure to assets with lower levels of volatility.

Australia’s economy pivoting – History is one thing, but what about the future?

The growth engine of the Australian economy is pivoting from mining to housing, which can be characterised as moving from a sector where Australia had a legitimate comparative advantage to a sector where it has a comparative disadvantage. The mining sector benefitted from ample sources of high-quality ore and close proximity to China, whereas the housing sector will likely eventually be weighed down by Australia’s highly levered consumer, expensive house prices and no limit on the supply response.
This “unbalanced rebalancing,” combined with investors’ increasing focus on stable retirement income, bodes well for a healthy dose of bonds in Australian investors’ portfolios in the years to come.

By Robert Mead, Managing Director and Head of Portfolio Management Australia, PIMCO

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[1] Source: Bloomberg. Data from 30 June 2008 to 30 June 2016. Indices: ASX200 Accumulation Index and Bloomberg AusBond Composite Bond 0+Index.
[2] Source: Australian Bureau of Statistics. Data from 30 June 2008 to 30 June 2015 (latest available demographics data).

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Low interest rates would suggest a return to the fundamentals of investing.

As interest rates continue to fall in Australia, investors may want to take their cue from the Reserve Bank of Australia (RBA).

At the time of its monetary policy meeting in early May, the RBA surely knew that fiscal stimulus was not going to be a key component of the budget to be released just a few hours later. As a result, the RBA, like many other central banks around the world, played the hand it was dealt and provided monetary stimulus to offset the lack of productive fiscal and structural support. Many commentators were critical of the RBA’s decision to lower the policy rate, but we believe it was the correct one. Australia’s economy has experienced what we would refer to as an “unbalanced rebalancing” from mining to housing, and without some sort of policy support, the Australian economy is vulnerable to a slowdown.

Like the RBA, investors may find that facing up to reality leads to much better decisions. Rather than invest for better days ahead, investors should position their portfolios in line with the fundamental economic backdrop today, the current valuation of assets and very importantly, the policy settings that are most likely to occur ‒ not what they think should occur.

The reality is with the Australian policy rate now at 1.75%, we have started a new chapter of the New Neutral for Australia, and this has implications for Australian investors. First, the hurdle to invest in assets, rather than sit on cash, has been lowered, again. Second, stable sources of real income are becoming more difficult to find. Finally, portfolio diversification is becoming even more important in the low-return environment as there is less of a “cushion” to absorb losses.

These implications suggest a return to the fundamentals of investing, which are sometimes forgotten even within the bond asset class. Why do investors buy bonds in the first place? For capital security, for income generation and for diversification. Implicit is the need to have some exposure to interest rates, or duration, as part of an overall portfolio allocation. Australian portfolios in general are already underweight interest rate exposure, so staying true-to-label and benchmark-aware in a core bond portfolio should be a prerequisite. Yet, many investors take structurally lower duration positions in their core bond portfolios. This comes with its own risks, including diminished down-side protection in market sell-offs and locking in a structurally lower level of overall carry.

The correlation between the Australian duration risk factor and the Australian equity risk factor actually has become increasingly negative over the past six months, based on analysis by PIMCO client analytics specialist Laura Ryan. This means equity-heavy portfolios are less volatile when investors include bonds in the mix, despite the low level of Australian interest rates.

Takeaways

Investors, especially those approaching or in retirement, may benefit from playing the hand they have been dealt in key ways:

1) acknowledge that expected returns will be lower and that chasing higher returns equals taking much higher risk;

2) take advantage of the effective ways to generate relatively capital-stable real income and consider investing in bonds;

3) diversify across asset classes to help reduce portfolio volatility, which, in our view, will be critical in the coming investment environment.

By Robert Mead, Head of PIMCO portfolio management Australia

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In its product assessment Zenith hold the PIMCO investment team in “high regard” and said the funds are well-managed recognising that PIMCO “benefits greatly from the support and input” of the global investment teams.

“Our conviction in the strategies has increased, reflecting the strong calibre of the domestic investment team and its continued ability to draw upon the insights and expertise of PIMCO’s diverse and highly experienced global team,” said Zenith.

Robert Mead, who manages both funds and heads portfolio management in Australia, said, “Investing in Australian fixed interest today requires a global perspective to truly cover the opportunity set. Our investment approach at PIMCO is one that has evolved with these realities and involves a unique mix of dedicated local expertise and a global coverage approach.”

“The funds have been through a full market cycle and have not only outperformed, but have done so with lower benchmark-like volatility with consistency of income generation,” Mr. Mead said.

Both funds are actively managed and have outperformed their respective benchmarks net of fees over the past 5 years (as at 30 June 2015). The funds add value through duration, sector positioning and security selection.

• The PIMCO EQT Wholesale Australian Bond Fund predominantly provides exposure to the Australian fixed interest market, as well as selective investment in global fixed interest markets. The Fund has delivered a net of fee return of 6.73% p.a. over the past 10 years (as at 30 June 2015), beating 100% of competitors (Morningstar data as of 30 June 2015).
• The PIMCO EQT Wholesale Australian Focus Fund, which was launched in February 2009, provides shorter duration exposure to the Australian fixed interest market. While this Fund has a shorter track record, it has still delivered a net of fee return of 5.19% p.a. over the past 5 years (as at 30 June 2015).

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The ‘free lunch’ for Australian investors is over.

With the Reserve Bank of Australia (RBA) policy rate now at 2% and Australian banks much more focused on raising capital than raising deposit funding, the “free lunch” that Australian investors quite rightly feasted on has ended.

Since the global financial crisis, Australian investors have earned very healthy real returns of about 2%-4% for taking essentially no risk by holding term deposits. This kitchen is now closed ‒ permanently.

This is a massive adjustment. While our developed-world peers have faced this reality of financial repression for well over five years, the Australian investor reaction to this new reality thus far appears to be somewhat backward-looking.

The hunt for yield has certainly been turned up a notch, and the source of income for many investors is migrating down the capital structure of the Australian banks into hybrids and shares. These alternate sources of income seem reasonable as long as the risks are well understood, portfolio concentration risk is avoided and the capacity for larger mark-to-market loss can be handled. For example, in the past two months alone, two to three years of expected dividend income from all Australian bank shares has been completely offset by mark-to-market capital loss. It is also important to recognize that, in a more capital-conservative world, historical dividend levels may be just that: history.

Australian investors have shown a tendency to look in the rearview mirror when making other financial decisions as well. In a recent study, we found that households are more comfortable taking on debt when interest rates are low AND asset prices have recently been appreciating. (See “A Look at Rising Household Debt in Australia and the Implications for Policy.”)

The good news is that in PIMCO’s New Neutral outlook, rates are expected to stay lower for longer and permanent capital loss will likely be confined to the most bubble-prone asset classes; yet, mark-to-market volatility is expected to be higher across the board.

Accordingly, we suggest investors:

• explicitly acknowledge that the real risk-free rate is now negative;
• be mindful of the additional risk in the instruments they use for income generation;
• focus more on expected capital price volatility of portfolio holdings;
• ensure there is sufficient risk-factor and geographic diversification in their portfolios;

and finally, remember when it comes to investing, there is no such thing as a free lunch.

By Robert Mead, Head of Portfolio Management, PIMCO Australia

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