Hybrid securities are often issued by banks to raise capital and offer investors a mix of fixed income in the same way as bonds combined with equity-features, meaning they can often provide a higher rate of return than regular debt securities.
What are hybrid securities?
In Australia, hybrid securities have been a popular choice among retail and institutional investors seeking steady income and franking credits, combining the income from bonds and the benefits of equities, these benefits do come with greater risk, inherent in the equity-like features. Holders of hybrid securities could also find themselves inferior to other creditors in the event of insolvency.
The Australian Prudential Regulation Authority (APRA) has announced plans to phase out these hybrid securities, with issuance set to cease by 1 January 2027, and a complete removal by 2032. This significant regulatory shift is expected to impact investors and the broader financial system.
Why are hybrid securities being phased out?
APRA’s decision to phase out hybrid securities is driven by concerns over their reliability during financial crises combined with investor lack of appreciation for the risk surrounding the investment option. The key reasons for this move include:
- Unreliable performance in stress situations: hybrid securities are designed to absorb losses in financial downturns. However, global case studies, such as the collapse of Credit Suisse in 2023, revealed that hybrid securities did not function as expected, leading to legal disputes and investor losses.
- Risk to retail investors: many retail investors have been drawn to hybrid securities for their steady returns without fully understanding the risks. APRA is concerned that these products could expose less-experienced investors to unexpected losses.
- Reducing systemic risk: By eliminating hybrid securities, APRA aims to strengthen the stability of Australian banks, ensuring they are better equipped to handle economic downturns without requiring taxpayer-funded bailouts. Hybrid securities are also a popular choice by SMSF investors in Australia, if huge losses are incurred this could cause massive ramifications for investment savings.
What will replace hybrid securities?
APRA has proposed alternative capital-raising mechanisms that are expected to be more reliable and transparent. These include:
- Tier 2 subordinated debt: A more straightforward form of regulatory capital that provides loss absorption without the complexities of hybrid securities.
- Common equity capital raisings: Encouraging banks to issue ordinary shares to strengthen their capital base rather than relying on hybrid instruments.
- Additional Tier 1 (AT1) capital with stricter terms: Any future AT1 instruments may have clearer, more transparent terms to improve investor understanding and market stability.
- Greater use of retained earnings: Encouraging banks to build capital buffers through profits rather than issuing complex hybrid instruments.
These measures aim to improve market confidence and ensure financial institutions remain well-capitalised during periods of economic stress.
Impact on investors
For investors currently holding hybrid securities, it’s important to understand how this transition will unfold. Key considerations include:
- Existing securities will remain until maturity: while new hybrid securities will no longer be issued after 2027, existing ones will continue to trade until they reach maturity.
- Potential changes in returns: investors relying on hybrid securities for income may need to explore alternative fixed-income or equity investments to replace lost yields.
- Diversification opportunities: this shift presents an opportunity for investors to reassess their portfolios and consider lower-risk alternatives that align with their financial goals.
The end of hybrid securities is a significant change for investors, however it doesn’t need to induce panic. Instead, this transition highlights the importance of understanding investment risks and ensuring portfolios are well-diversified. If you currently hold hybrid securities, it may be worth assessing your investment objectives and risk tolerance, to determine what asset classes could replace these within your investment portfolio or if a diversified, income generating portfolio, such as Stockspot’s Topaz Income Portfolio could offer an alternative.
The phasing out of hybrid securities in Australia marks the end of an era for this complex investment product. While the decision is aimed at strengthening the financial system and protecting investors, it also signals a shift in how banks will raise capital in the future.
In this follow-up article, we explore investment alternatives for when hybrid securities are phased out.
