In September, APRA made a significant announcement to the Australian banking sector and the fixed income market with its proposal to remove Additional Tier 1 Capital (known as AT1 or Hybrids) from the capital structure of banks. Currently 1.5% of bank capital is required to be held as AT1, but from 2027 (over a transition period until 2032) this will be phased out. The Australia hybrid market is relatively small at $43 billion, especially when compared with Government issued bonds at are over $1.5 trillion and financial institution bonds near $600 billion. The particular ‘sweet spot’ of hybrids has been twofold – firstly, they have been ASX listed and available to retail and institutional investors, and secondly, they have carried a tax effective gross up yield through imputation credits (again, attractive to retail or private investors)  

Hybrids (AT1 capital) are designed to enhance the stability and resilience of banks. It acts as a buffer to absorb losses when a bank’s equity capital falls below a certain threshold. The name ‘Hybrid’ stems from the ability for this capital to convert into equity in times of stress when the equity of a bank falls below a threshold (5.125% for Australian banks). This ‘tops up’ a bank’s equity to protect deposit holders. Below is a simple look at a bank’s capital structure. 

The large banks are required to replace this 1.5% of capital with 0.25% equity & 1.25% Tier 2 (subordinated debt), whereas small banks fully replace AT1 with Tier 2 capital. The potential risk for the banking system is that by removing hybrids and replacing largely with Tier 2, APRA is explicitly increasing bank leverage (less equity, more debt). Australian banks continue to be among the best capitalised banks in the world, and we see these actions by APRA as directed to retail investors and not wanting equity “bail-in” provisions. The increased risk is minimal. Interestingly, insurers (eg: IAG) are permitted to continue utilizing hybrid securities in their capital structure. 

To restate, the purpose of hybrids (AT1 capital) is to improve stability of banks in times of stress. In the wake of Credit Suisse’s collapse in 2023, APRA have become increasingly concerned regarding the underlying investors in these hybrid securities. Of the $43bn of hybrids in the market in Australia, APRA suggest that 53% are held by ‘retail’ or ‘smaller’ investors. In times of stress, the idea of converting the hybrids to equity has given APRA concerns that imposing losses on these investors would bring contagion (and political) risk and undermine confidence in the system in a crisis. Effectively, in trying to protect the bank’s deposit holders, they risk impacting ‘Mum & Dad’ investors, possibly defeating the purpose of the capital in a conversion event. Other reasons for the change are: 

• The collapse of Credit Suisse showed AT1 to be ineffective at stabilising a bank in a crisis. 

• Removing AT1 simplifies capital structure for banks.  

We acknowledge the notion of protecting retail investors, though we do not accept why hybrids could not be issued in the Over-The-Counter wholesale (OTC) markets for the use of institutional and sophisticated investors who understand the risks of the instruments. 

Hybrids are popular investments for retail investors as: 

• The franking credits distributed are highly tax effective (especially within varying tax environments such as superannuation). 

• They are effectively the only direct fixed income securities available on the ASX (which is a deficiency when compared to other capital markets). 

• Advisers can be incentivised to participate in these deals to receive a ‘Selling Fee’ (note - this would be a breach of policy at Cameron Harrison where all selling/placement fees are rebated to the client). 

As these investments are phased out, it leaves a large gap for investors looking for yield and capital stable direct, liquid investments on the ASX. The Cameron Harrison Core Interest Income Strategy has had a low allocation to hybrids (15-25%). The APRA announcement has seen prices increase for these securities as investors acknowledge the reduced supply, benefiting current holders of hybrids.  

Now more than ever, investors can benefit from structured investment advice to gain an allocation to high-quality, income generating, capital stable interest income securities. The fixed income asset class continues to offer attractive returns with the RBA Cash Rate at a 13-year high. With the removal of hybrids, investments to consider are: 

Whilst we do not accept APRA’s rationale for the phasing out of hybrids to both retail and OTC investors, APRA is going to institute this change with detriment to the balanced capital structure of banks (and the health of Australian banks). Post the collapse of Credit Suisse, APRA seeks the uncomplicated and absolute power to write-off T2 capital rather than conversion to equity. The relevance of ‘retail’ investors being unsophisticated is we believe a ‘red-herring’ as APRA has no such reservations as to other products regulated by ASIC and listed on the ASX. 

Cameron Harrison, through its suite of fixed income strategies, see a vast, deep, liquid and efficient market for over-the-counter (OTC) fixed income. Other fixed income securities with comparable risk and returns are already significant components of our long-standing Core Interest Income Strategy (wholesale), and whilst these changes are disappointing (and unnecessary) to retail investors on the ASX, such regulatory changes offer us future opportunity.