The End of Bank Hybrids: Filling the $43Billion Gap

Bank hybrids are in the early throws of a slow and lingering death in the wake of APRA decision to phase them out for regulatory purpose. By 2032 they will cease to exist, replaced by a mix of predominately tier 2 capital (subordinated bonds) and a sliver of common equity, for the majors at least. Regional banks will have to settle for just tier 2. I have commented on the initial proposal and details in the past, see here for a refresh.

The phasing out of hybrids will leave a $40bn hole in investors’ sandpit of investable options, particularly the corner of the sandpit set aside for investments held for their income generating capabilities while exposing investors to only modest capital volatility. The first stage of this process has already kicked off with just under $1bn of ANZ of hybrids called in March 2025, and a further $1.7bn to be called next month (September).

What alternatives can investors consider?

Will the regulatory capital set to replace hybrids, namely tier 2, do the job? Not for retail investors, no. Tier 2 is a wholesale market product, with retail investors not permitted to play (directly). There are limited fund options, not pure tier 2 funds at least. Nonetheless, the return dynamics are different. The spread offered on bank hybrids have averaged around +290 bps over the past five-deals, whereas average tier 2 spreads on the other hand have been around 100 bps lower, at around +190 bps (past five-deal average).

Is an increasing allocation to bank stocks an option? It’s always an option, but is it a prudent one? The decision here is nuanced, and would be a function of an investor’s age, investment horizon, risk appetite, existing bank stock allocation and so on. Generically though, a relative increase in allocation to stocks in place of prior hybrid allocations would increase portfolio risk, all other things being equal. Over the past five years, and probably longer, volatility of bank stocks (price movement), on a month-to-month basis, has been four times that of hybrids (price). Yield wise, hybrids are yielding around 6.3% (major bank average), whereas major bank dividend yields are sub 4.0% (ASX 200 Bank Index average).

An important consideration for hybrid investors considering allocating into bank stocks is the prevailing ‘frothy’ valuations, particularly CBA and WBC. Over the past 12-months prices have risen +24% and 254% respectively – although some of the heat has come out of CBA’s price having fallen 11.0% since the end of June. Nonetheless, still impressive, especially given pre-provision earnings fell through FY’24 and expectations for earnings growth over the year ahead are a modest 2% - 4%. NAB (+11.6% 12m return) and ANZ (+12% 12m return) have seen more muted price performance, but still robust nonetheless, especially given the relatively flat growth observed in bank earnings and dividends over the past decade or so. Earnings Per Share (EPS) and Dividend Per Share (DPS) have not grown in ten years with EPS and DPS for the ASX 200 Bank index flat to slightly down on levels observed in 2015. Over the same period the index itself is up over 70.0%.

What about deposits?

Prudent, but not a like for like alternative given the spread differential, i.e. close to 300 bps. Next.

I have previously provided some thoughts here on potential alternative investment options, notably Residential Mortgage-Backed Securities (‘RMBS’) and Asset Backed Securities (‘ABS’). As per the attached note, these are not an asset class available to retail investors but accessible through managed funds nonetheless. I won’t re-hash what I have previously written, but rather highlight the continued strength of the RMBS / ABS market. Last year saw $80bn of RMBS and ABS issuance in A$, across 100 individual transactions from 57 organisations. A record year, comfortably exceeding prior peak water marks ($64bn). This also represents more than triple the average annual volume of major bank debt issuance. A repeat performance this year is unlikely as 2024 was an anomaly, but 2025 is expected to be well ahead of 2023 issuance levels and the broader growth trend.

And here’s the marketing pitch. At Mutual Limited we have two retail funds that invest in RMBS and ABS. Both fund’s core focus is steady income generation with capital stability, arguably the same dynamics that drew investors to bank hybrids. The first of these two funds is the Mutual Credit Fund, which can have up to 30% allocated to RMBS and ABS, while the balance is predominantly across floating rate debt issued by APRA regulated entities. The fund returned +6.65% (net of fees) for the year ending July 31st, with a prevailing running of 6.25%.

Next is the Mutual High Yield Fund, which has a larger allocation to RMBS and ABS, typically up to 65%. This fund returned +9.98% (net) over the past year, with a prevailing running yield of 7.45%. For details on these funds, and our other two funds, please visit our website here. Both funds delivered monthly returns with materially less volatility than hybrids, 0.39% for MCF and 0.56% for MHYF vs 7.35% average for major bank hybrids.

Before closing off, other alternatives are coming to light also that merit comment. Year to date we’ve seen the launch of a couple of Listed Investment Trusts, or LITs, which has attracted some attention in the financial press, see here: AFR | Race is on to plug $43bn bank hybrid market. LITs have been around for a while, but have not necessarily caught on with retail investors, not in scale at least. Nevertheless, a few new LIT’s are being marketed around, ostensibly structured in such a way as to replicate hybrid type returns. All I’ll say is be wary of transparency, underlying credit quality, and fee structures. Do your due diligence.