Bank Shares May Rally on APRA Hybrids Review

The banking regulator’s announcement that it plans to phase out bank hybrids over the next 7 years could see the price of hybrids rise as they become scarcer and see an increase in  the value of bank shares as investors price in a possible rise in dividends as banks seek to utilise available franking credits according to IAM’s Matthew Macreadie, the executive director of credit strategy and portfolio management at Income Asset Management.

APRA is proposing that banks phase out the use of AT1 capital instruments, often called hybrid bonds or simply hybrids, and replace them with cheaper and more reliable forms of capital that would absorb losses more effectively in times of financial stress.  Any moves could impact retail investors, who hold more than 50 per cent of hybrids on issue.

Hybrids sit at the bottom of a bank’s debt capital stack and just above common equity. They have characteristics of debt and equity, in that they pay investors a set level of income, though they rank below bondholders and depositors in the event of a bank’s collapse.

APRA recently said it has three options: maintaining the status quo, redesigning bank hybrids to make them operate more effectively, or replacing hybrids with other existing, more reliable forms of capital.

According to IAM’s Matthew Macreadie, if hybrid bonds are replaced, this could potentially boost the value of hybrids bonds held by investors as they become scarcer.  “This is a result of APRA effectively removing hybrids as an asset class for investors from 1 January 2027,” he said.

“Bank share prices may factor in higher franking credits being attached to future dividends as a result of the removal of hybrids as an asset class. This could see the gross dividend yield on a major bank share increase from the current 6 per cent to 7 per cent level.

“Existing hybrid bonds held by investors such as SMSFs should provide good, regular income up until their call dates when they are redeemed. The door hasn’t closed on capital instruments being in the hands of retail investors in the future. Thus, a bank could issue ASX-listed Tier 2 with franking credits attached to meet the needs of SMSF investors,” he said.

“With banks paying 30 per cent corporate tax, hybrids were a nice way of monetising the franking balance that doesn’t get paid out as dividends.  Thus, investors such as SMSFs may look to replace hybrids with ASX listed Tier 2 going forward,” Mr Macreadie said.

The removal of hybrid bonds from the capital structure of banks reduces the income generating assets available to retail investors.  IAM is currently developing products that will allow individual investors seeking income certainty access to the broader fixed income market. Hybrid instruments issued by other sectors such as insurance are not part of the reform.  These assets will also likely see a lift in demand from investors seeking income.

The proposed changes follow last year’s global banking turmoil where several US and European banks either failed or needed to be resolved in short succession, with several governments having to intervene to minimise the risk of contagion and financial system instability.

“The purpose of hybrids is to absorb losses in the instance of a crisis. Unfortunately, events last year highlighted that hybrids did not fulfil this function in a crisis situation due to their complexity and the risk of causing contagion. These risks are greater in Australia due to the high proportion of hybrid securities held by retail investors,” he said.

APRA’s announcement follows an extensive consultation process that began with the release of a discussion paper last year asking for feedback from the financial services industry on a range of ideas to improve the effectiveness of hybrid instruments for use in a potential bank stress scenario. APRA received feedback from 26 submissions and more than 40 engagements.

APRA has proposed starting the transition to a simpler bank capital framework from 1 January 2027, with all current hybrid bonds on issue expected to be replaced by 2032. For existing investors, APRA said it does not envision an immediate impact with AT1 capital instruments continuing to be eligible as regulatory capital until their first call dates.