Navigating the Hybrid Waters

What are Hybrid Securities?

Hybrid Securities are investment instruments offered predominantly by Australian corporate banks to enhance capital requirements as mandated by Basel III obligations. Although the composition of Hybrid Securities can be complex, they fundamentally blend debt and equity characteristics. This positioning allows investors to earn 2-3% above bond rates while strategically placing themselves on the risk curve.

At present, Hybrid Securities represent approximately 1.5% ($41 billion) of the capital of Australian banks, with the majority of this capital being raised from Australian investors.

The Regulatory Change:

The collapse of Credit Suisse and the subsequent write-off of their Hybrid investors has drawn significant attention to these complex securities. In response, the Australian Prudential Regulation Authority (APRA) has raised concerns regarding the efficacy of these securities during periods of financial stress. Consequently, in late 2024, APRA decided to phase out bank hybrids beginning in 2027, with complete elimination by 2032. Banks will be permitted to replace these hybrids with 1.25% tier 2 subordinated debt and 0.25% tier 1 common equity.

What happens next?

Investors, now flush with cash, will likely seek and redeploy their capital into similar investment vehicles. While Hybrid Securities are available from corporations outside the banking sector, the majority are issued by the big four Australian banks. Managed funds are poised to capitalize on this regulatory shift, expecting the $41 billion in surplus cash to flow into the market. Already, new Listed Investment Companies (LICs) and funds have emerged with the objective of investing in the Australian credit market, offering similar risk and return profiles.

Investors will face the decision of either moving up the risk curve to invest in more equity-like instruments or moving down the curve into subordinated debt products. Regardless, investors will seek to redeploy their capital with a similar risk and return profile, while banks will aim to raise more subordinated debt.