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What's next for bank hybrids?

On 21 September, the Australian Prudential Regulation Authority (APRA) posted a media release seeking feedback on improving the effectiveness of Additional Tier 1 (AT1) capital in a potential bank stress scenario. This has come about in the wake of the Credit Suisse hybrid write-off in Switzerland, as APRA is “concerned that AT1 capital instruments would not operate as originally intended due to certain design features and market practices”. APRA noted that “AT1 has not been effective in absorbing losses” before the point of failure noting that Credit Suisse continued to make discretionary hybrid distributions “despite incurring sustained losses and facing an uncertain profitability outlook”.

AT1 hybrids are perpetual and convertible bonds that pay discretionary, non-cumulative coupons to investors, designed to protect depositors and senior creditors where the bank or insurer (the issuer) experiences severe stress through conversion to equity or complete write off. These securities, as well as common equity and Tier 2 instruments, form the regulatory loss-absorbing capital of a bank. Despite the complexity of these instruments, the domestic AT1 investor base is not dominated by institutional investors and almost entirely listed on the ASX. The typical buyer, in our view, is clients of private wealth and private banking firms.

Three possible options

APRA is exploring three potential options to make AT1 capital more effective in absorbing losses:

  1. changing the design features to ensure AT1 capital absorbs losses earlier in a stressed scenario,
  2. making changes to the level or mix of regulatory capital requirements to reduce the reliance on AT1 capital, and/or
  3. shifting the AT1 investor base away from domestic retail investors.

The first option would likely result in raising the capital trigger level that results in a conversion or write-off of AT1 capital, and/or limiting distributions where banks are under duress. This is currently where the Common Equity Tier 1 (CET1) ratio reaches 5.125%, in-line with international guidance and standards. Noting some countries like the United Kingdom and China have “high trigger” ratios of 7%.

Raising this capital trigger would make AT1 hybrids inherently riskier, and therefore primary issuance under this new policy would require higher credit spreads given the higher likelihood of conversion or write off. Given the major bank AT1 capital is rated BBB-, this would likely see a credit rating downgrade to sub-investment grade, which may temper demand from institutional investors.

We do not see a downgrade of the security rating as being material to the traded (current hybrids) performance, however a higher trigger will require higher spreads. Given Australian Banks have maintained CET1 ratios of greater than 8% for more than a decade, we would likely be opportunistic in allocating at higher spreads due to higher triggers.

The second potential option is reducing the reliance on AT1 capital as a proportion of total regulatory capital. This can be done by either :

  1. reducing the minimum amount of AT1 capital (currently 1.5% of RWA), and potentially increasing other capital requirements (CET1, or total capital via an increase in the proportion of Tier 2 capital), or
  2. capping the maximum amount of capital that is eligible to be counted as AT1 – with excess to effectively be very expensive senior funding. The latter seems the more rational, but it is complicated. 

The third option proposed by APRA is to hinder access from retail investors (potentially via minimum parcel sizes), effectively limiting investment to wholesale investors. Under this option, we would expect more issuers to come to market to issue AT1 capital before any introduction of retail limitations given (1) they can capture more market demand given retail would be locked out from investment once any changes are implemented, and (2) to issue AT1 hybrids at a lower cost of funding, given domestic wholesale AT1s have historically traded with higher spreads (~50bps) to more liquid ASX-listed AT1s. Tenors would likely also be longer to lock in lower spreads.

Demand for hybrids from retail has been hot over recent years, and this demand is only growing as coupon income has materially risen (the 3mBBSW increase alone has roughly increased hybrid income by $1.7 billion p.a. to local investors) and some of that needs to be reinvested. This might see increased demand for ASX-listed bonds, as well as the secondary AT1 market, as retail investors crowd in for the last dance. This would make the perfect environment for issuers to come to market with lower spreads and longer tenors before the potential new policy is implemented.

Demand may also turn to Listed Investment Trusts (LITs) which went out of fashion after numerous domestic LITs started trading at material discounts to NAV. However, this will take time given there is still more than $40 billion locked up in current ASX-listed AT1s.

The degree of change is key

As a general comment, APRA is likely to receive responses to this consultative process that points out the reality that retail investors hold CET1 (ordinary shares) of the banks in vastly larger volumes than AT1 hybrids and so any significant event, however unlikely, that requires absorbing losses through equity will still impact materially on retail investors, and earlier than a scenario involving the absorption of AT1.

Indeed, the likelihood of an event requiring AT1 absorption has been made remarkably remote by the solid actions of APRA over its 25-year history, and particularly in the last 10 years via bolstering bank requirements in capitalisation, funding, and liquidity.

Any of the above potential outcomes are likely to change the price and volume dynamics for AT1 hybrid issues assuming one or more are implemented but the extent of these dynamics will depend ultimately on the outcome of the consultative period which ends on 15 November 2023, and APRA’s response to this process.


Charlie Callan, CFA is an Associate Director, and Ben Haseler, Ravi Reddy, and Christian Belvedere are Analysts at BondAdviser. This article is general ionformatio and does not consider the circumstances of any investor.


Steve Martin
October 25, 2023

I returned to the hybrid market just recently as the equity risks are growing. I find it galling that retail investors are denied access to IPOs, so the only way in is after they list and the initial investors are able to get the premium. By making IPOs only accessible to sophisticated investors or institutions the risk is added to retail investors by the increased cost above the redemption amount. As Mb correctly says anyone can buy these hybrids on the market.

The day that one of the big 4 doesn't honour the redemption in cash, we have more problems in the economy than the hybrid market.

Anthony Asher
October 25, 2023

My understanding is that the real risk is not conversion to equity, but total write-off as with the Credit Suisse AT1bonds. I read somewhere that the Saudi's and other large shareholders put pressure on the regulator not to dilute their already loss-making shareholdings.
I have only read one hybrid loan document and it required APRA's permission for an equity conversion - with a total write off being the other consequence. The big banks have hundreds of thousands of shareholders and - I suspect- relatively fewer hybrid holders. Politics should not come into it, but ...

October 24, 2023

Small investors with direct exposure to bank hybrids will confirm their price is less volatile than shares and their interest payments more stable than dividends. None of our hybrids ceased paying interest during the testing GFC times, but many blue chip shares reduced dividends. APRA doesn't like retail investors buying ATI capital/bank hybrids because retail investors will be the ones hurt and complaining loudly if APRA needs to order a conversion of hybrids into shares to maintain bank liquidity during some future banking crisis. Hybrids held by retail investors tie the hands of APRA. For small investors, reliable hybrids are an alternative to unreliable share dividends and this needs to be acknowledged, rather than just considering hybrids as an APRA liquidity control lever of last resort. APRA should be urged to leave hybrids alone and not make them even harder for retail investors to purchase. Better still, wind back the ineffective and unfair Design and Distribution Obligations (DDOs) that prevent retail buyers participating in new hybrid releases. From Footnote #22 of the APRA discussion paper: “Banks are currently subject to principles-based design and distribution obligations (DDOs), which require AT1 issuers to take reasonable steps to distribute instruments in line with their target market determination. Some issuers are now requiring clients to obtain written confirmation from a financial advisor that the investor has received appropriate advice before they will distribute the product to the investor, or evidence that the client is a sophisticated investor within the meaning of the Corporations Act (such as evidence the client has net assets of at least $2.5 million). There has not been a material reduction in non-wholesale investor participation in new issues of AT1 instruments following the introduction of DDOs. Additionally, DDOs only apply to primary issuance of AT1, and not to trading or purchases on secondary markets.” DDOs have been criticised on this forum in articles and discussion. DDOs give institutions a windfall gain by allowing them to buy new hybrids for $100, then selling them later for >$100 to retail investers. On the issue of hybrids can APRA be persuaded to recognise and act in the interests of retail investors? Who advocates on behalf of retail investors? A submission to the APRA inquiry from FirstLinks reflecting the views of forum participants would be useful.

October 20, 2023

More fiddling, resulting in increased cost to retail investors, who still have the same risk, but buy hybrids the day after the release on the market. Equities are equally risky and any investor, either sophisticated( by virtue of your value,not knowledge) or not sophisticated , can buy as many risky shares on market as they like.

A Thilo
October 20, 2023

The reality is hybrids offer a route to a fair and reasonable relatively safe income stream to small cap investors. Yes some fell well below par in the covid shock but not for long. Maybe the regulators should concern themselves to setting limits to limiting the equity ratio small retail investors can hold, rather than current requirements that solely lock them out of the IPO process which then only increases their exposure.

Colin Edwards
October 20, 2023

How much more meddling with bank hybrids is necessary? As a long-term small investor I am already pi**ed off for having to pay a financial adviser to issue me a certificate to say I'm safe to take up a new issue, or else buy later at more expense on the ASX.

October 20, 2023

Well said
DDO Direct Distribution Obligation is obviously not effective Retail investors are still lining up and getting any new bank Hybrids.CBAPM at big demand after the issue and retail investors buy at ASX at higher prices.
If Bank Hybrids are that risky than bank shares are also risky ? With a so called Crash both will suffer big time.

October 19, 2023

Should the third option of a minimum parcel size (presumably of $100k or thereabouts) be enacted, I would assume that retail investors would then simply change from investing directly in Hybrids to using one of the managed funds or ETFs that are available. Which would give them exposure to a wider range of issuers, but given that almost all of the issuance is from banks and is likely to be highly correlated should there be a crash, doesn't necessarily improve their situation much.


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