In today’s volatile and uncertain market where term deposit rates remain consistently low, investors continue to be attracted to the regular and defined distribution payments bank hybrid securities can offer. However, despite their many positive features, bank hybrids carry more risks than many investors realise.

On the surface, bank hybrids seem like a safe, low-risk investment option. They pay a steady return and seemingly help to protect capital – acting like a bond or fixed interest security. However many investors do not realise that they are far more complex and carry significant risk, particularly since the Basel III reforms were adopted by the Australian Prudential Regulation Authority (APRA) in 2013.

What are bank hybrids?

Banks issue hybrid securities to help raise capital in return for distribution payments. Although they are listed on the ASX, bank hybrids are not the same as investing in a bank’s ordinary shares nor are they like investing in traditional fixed interest bond securities. Investors are not shareholders, nor secured creditors in the event of default.

As the name suggests bank hybrids are a form of bank equity that combines elements of both debt and equity securities. They pay a rate of return until a fixed date, like a bond, and may provide a higher rate of return than regular debt securities.

There are two broad types of bank hybrid securities.

Tier 1 hybrids – commonly called additional tier 1 (AT1), capital notes or convertible preference shares

• no maturity date (due to convert into ordinary shares in the issuing bank on a fixed date)
• distributions are paid subject to the issuing bank’s discretion (if not paid, the bank has no obligation to pay)
• face value may be repaid earlier than the fixed date (at the issuing bank’s discretion)

Tier 2 hybrids – commonly called subordinated notes

• have a set maturity date
• distributions are subject to solvency conditions (if not paid, it accrues and due when the issuing bank is deemed solvent)
• face value may be repaid earlier than the fixed date (at the issuing bank’s discretion)

Why are they so risky?

APRA’s Chairman, Wayne Byres, is quoted in August as saying that bank hybrids act as a “first line of defence” when a bank is facing difficulties – a scary thought.

By very design, bank hybrids protect the issuing bank’s depositors by removing risk from the bank and shifting it onto the investor. Repayment of capital is not secured, and is not covered under the Financial Claims Scheme, which means the Australian Government will not repay the investment if the bank defaults. Also, if the issuing bank becomes insolvent, bank hybrid holders are likely to have to wait in the long line of creditors to be repaid.

If the issuing bank was to experience financial difficulty, hybrid distribution payments can be deferred for a number of months, or even years. Issuing banks are also able to convert hybrid securities to shares at their discretion.

Although here in Australia we are fortunate enough not to have experienced an event that has caused banks to take such actions as yet, we are living in an extremely volatile world (some would argue perhaps the most uncertain we’ve seen) and a “trigger event” is far more likely than most investors would like to think.

APRA’s new strict regulations

The role of APRA is to oversee banks, credit unions, building societies, insurance groups and most of the superannuation industry, and have a number of measures in place to ensure banks have sufficient buffers in the event of a financial crisis or recession.

Capital trigger event

APRA commonly judges a bank’s strength by their common equity tier 1 (CET1) capital ratio. This ratio is the measurement of a bank’s core equity capital compared with its total risk-weighted assets and gives a good indication on their performance and solvency.

In a “capital trigger event” APRA has the power to restrict or stop tier 1 hybrid distributions, and in some cases even write off the value of hybrid securities, if the issuing bank’s CET1 capital ratio falls below certain thresholds.

• If a bank’s CET1 capital ratio falls below 8%, APRA will restrict dividends and tier 1 hybrid distributions by 40%.
• If a bank’s CET1 capital ratio falls below 7.125%, APRA will restrict dividends and tier 1 hybrid distributions by 60%.
• If a bank’s CET1 capital ratio falls below 5.375%, APRA will restrict dividends and tier 1 hybrid distributions by 100%, and may even write off the value.

Non-viability event

Although APRA has not provided defined guidelines surrounding what constitutes a “non-viability trigger event”, it is likely that they may consider a bank non-viable if they suffer significant financial stress, become insolvent or are unable to raise money in public or private markets.

In this situation, APRA has the ability force the issuing bank to convert some or all of its Tier 1 or Tier 2 hybrids into ordinary shares. Such an occurrence could potentially mean significant loss for investors as the shares could be worth less than the hybrids.

These measures are extreme and for hybrid investors, rather unsettling. Despite pressure from banking lobby groups, APRA remains steadfast on their decision – these rules are here to stay.

A well-rounded strategy

While allocating a small portion of a portfolio to bank hybrid securities can be effective as part of a wider well-rounded strategy, an approach highly focused on this asset class is fraught with danger. Particularly when you consider that many hybrid investors are also highly exposed to significant holdings in bank stocks as well.

It is critically important that investors take the time to fully understand what the complexities and challenges are with bank hybrids both now, and in the future, and consider if the returns adequately compensate the risk. Our suggested investment strategy has always been to adopt a truly diversified portfolio with an exposure to a wide variety of investment areas and risks. Particularly in today’s environment, we also place an amount of emphasis on downside protection during challenging market environments – like we have seen over the past 12 – 18 months.

If you are, or were, a hybrid investor with a preference for capital preservation now might be the time to revisit these investments. If you would like to discuss anything outlined in the above, or your personal portfolio position, please feel free to contact us on (07) 3391 5055, or via email, advice@mgdwealth.com.au.

Disclaimer: This article contains general information only and is not intended to constitute financial product advice. Any information provided or conclusions made, whether express or implied, do not take into account the investment objectives, financial situation and particular needs of an investor. It should not be relied upon as a substitute for professional advice.