Register For Our Mailing List

Register to receive our free weekly newsletter including editorials.

Home / 453

Hybrids alongside corporate bonds a good balance

In today’s low interest rate environment where term deposit rates have remained sustainably low, investors have been attracted to the regular distribution payments and higher-return profile from hybrids. However, despite their many positive features, hybrids do carry higher risks versus Australian corporate bonds - which many investors don’t realise.

While allocating a small portion to hybrids can be effective, an approach highly focused on this asset class will pose problems. There are three primary risks to hybrids that will be explored:

  1. Hybrids historically have had a higher correlation to equity markets
  2. Hybrid debt issues are less frequent than Australian corporate bond issues
  3. Hybrids have significant call risk relative to Australian corporate bonds

Our suggested approach would be to adopt a diversified portfolio with adequate exposure to Australian corporate bonds alongside hybrids. Particularly in today’s environment, we place an emphasis on downside protection during market turbulence – like we have seen in the past few months.

There’s no doubt hybrids have a place, though the current returns from hybrids (especially financial hybrids) do look on the expensive side on a risk-reward basis. The yield to expected maturity/first call on bank hybrids are around 3-4% (unfranked). We believe five-year bank hybrids offer better value at around the 5-6% mark (unfranked).

1. Hybrids historically have had a higher correlation to equity markets

Over the GFC period, bank hybrids experienced close to a 20% drawdown (or price decline), which was primarily attributable to capital losses from the discount margins on these securities increasing from around 1% pre-GFC to around 5.5% post-GFC. Using this as a proxy for the current environment, if discount margins were to increase from the current 2.75% to around 5% over the next year, the capital loss would be around 6.5% offset by 2.75% income – thus, a drawdown of around 3.75%.

The recent experience for bank hybrids has been more muted. Bank hybrids are down by around 2-3% (in price terms) over calendar 2022 YTD compared to the ASX200, which is down by closer to 10%. On the other hand, the Australia corporate bond index has outperformed being down by around 1-2% (in price terms).

The GFC period was highlighted by:

  1. A fear of economic slowdown/banking crisis
  2. Protracted equity market weakness, and
  3. Large drawdowns (bank share prices falling by 20% plus).

The current sell-off is different in that it has revolved around higher inflation/higher interest rates alongside the Ukraine/Russia conflict.

The chart below gives a longer-term perspective of credit (or discount margins) for four types of credit investments: BBB rated bonds, US High Yield, CoCo (non-AUD, AT1/Hybrids), and Australian AT1/Hybrids). The last data point is 26 January 2022.

While BBB rated bonds do have some spread volatility (albeit, less so than AT1/hybrids), the bulk of the Australian corporate bond market sits in the A rating and above. A rated bonds have historically had very low spread volatility and risk-reward characteristics are better given potential drawdown risk.

Source: BofA, ICE

2. Hybrid debt issues are less frequent than Australian corporate bond issues

The Australian corporate bond market has grown by more than 40% since 2010. Currently, there are over A$1 trillion Australian corporate bonds outstanding across governments, semi-governments, asset-backed securities, financial and non-financial corporates, inflation issuers, and hybrids.

However, the hybrid market is only a tiny segment of the Australian corporate bond market at around A$47 billion or 5% of Australian corporate bonds outstanding. Most of the debt issues are classified as ‘convertible preference shares and capital notes’ and issued from several financial institutions (mostly the major banks and Macquarie) – which also creates significant concentration issues with the Australian banking sector.

In years past, hybrids were also used by corporates (for example, Crown, Nufarm, and Qube) to obtain a level of equity credit for which to improve credit metrics. Rating agencies have since made this process more onerous on issuers, which, alongside issuers being able to get cheap funding from the corporate bond market, has seen a tailing off in corporate hybrid supply.

The issue hence becomes one in which investors can only get exposure to hybrids via the banks. As debt issues are less frequent in nature, replacement of capital then becomes very difficult, which poses reinvestment risk.

Generally, the hybrid market is also not a heavily secondary traded market – the number of trades per day is around 1,500 with a value of approximately A$700 million. For example, the bid-offer spreads (i.e., the difference between the market price at which the hybrids can be bought and sold) for CBA hybrid securities can be larger than those for its shares.

Australian Bond Segments

Source: ASX Hybrids monthly report, February 2022

3. Hybrids have significant call risk relative to Australian corporate bonds

The perpetual nature of many hybrids (especially the financial hybrids) means there is essentially no guarantee of getting your money back and thus no reliable yield to maturity (%). There are ‘reset periods’ with ‘reset margins’ but there is no end date for getting paid back. For this reason, investors are generally better placed to assess the running yield (%) for that period and then make a judgement as to whether they are comfortable or not.

Call risk also tends to rise in a higher interest rate environment as the issuer can hold onto old, low-rate hybrids rather than issuing new hybrids which have a higher rate of interest. Generally corporate bonds have a hard bullet maturity. All-else-equal, investors can be comfortable with the yield to maturity (%) on offer.

The other issue is that if a hybrid isn’t redeemed it’s probably going to be a result of wider market turbulence. So, if an investor wanted to exit, they’d be selling into the eye of the storm and potentially running into liquidity issues and realising a sizeable capital loss to do so.

 

Matthew Macreadie is a Credit Strategist at Income Asset Management, a sponsor of Firstlinks. To discuss this topic further and access corporate bonds please reach out IAM. This article is general information and does not consider the circumstances of any investor. Please consider financial advice for your personal circumstances, including eligibility for these investments.

For more articles and papers from Income Asset Management, please click here.

 

RELATED ARTICLES

Corporate bonds: why now and in what structure?

A closer look at defensive assets for turbulent times

Creating a bulletproof investment portfolio

banner

Most viewed in recent weeks

Why the $5.4 trillion wealth transfer is a generational tragedy

The intergenerational wealth transfer, largely driven by a housing boom, exacerbates economic inequality, stifles productivity, and impedes social mobility. Solutions lie in addressing the housing problem, not taxing wealth.

The 2025 Australian Federal election – implications for investors

With an election due by 17 May, we are effectively in campaign mode with the Government announcing numerous spending promises since January and the Coalition often matching them. Here's what the election means for investors.

Finding the best income-yielding assets

With fixed term deposit rates declining and bank hybrids being phased out, what are the best options for investors seeking income? This goes through the choices, and the opportunities and risks involved.

What history reveals about market corrections and crashes

The S&P 500's recent correction raises concerns about a bear market. History shows corrections are driven by high rates, unemployment, or global shocks, and that there's reason for optimism for nervous investors today. 

Howard Marks: the investing game has changed

The famed investor says the rapid switch from globalisation to trade wars is the biggest upheaval in the investing environment since World War Two. And a new world requires a different investment approach.

Welcome to Firstlinks Edition 605 with weekend update

Trump's tariffs and China's retaliatory strike have sent the Nasdaq into a bear market with the S&P 500 not far behind. What are the implications for the economy and markets, and what should investors do now? 

  • 3 April 2025

Latest Updates

Investment strategies

4 ways to take advantage of the market turmoil

Every crisis throws up opportunities. Here are ideas to capitalise on this one, including ‘overbalancing’ your portfolio in stocks, buying heavily discounted LICs, and cherry picking bombed out sectors like oil and gas.

Shares

Why the ASX needs dual-class shares

The ASX is exploring the introduction of dual class share structures for listed companies. Opposition is building to the plan but the ASX should ignore the naysayers and bring Australia into line with its global peers.

The state of women's wealth in Australia

New research shows the average Australian woman has $428,000 in net wealth, 40% less than the average man. This takes a deep dive into what the gender wealth gap looks like across different life stages.

Investing

The two most dangerous words in investing

Market extremes are where the biggest investment risks and opportunities lie. While events like this are usually only obvious in hindsight, learning to watch out for these two words can alert you to them in real time.

Shares

Investing in the backbone of the digital age

Semiconductors are used to make microchips and are essential to a vast range of technology and devices. This looks at what’s driving demand for chips, how the industry is evolving, and favoured stocks to play the theme.

Gold

Why gold’s record highs in 2025 differ from prior peaks

Gold prices hit new recent highs, driven by a stronger euro, tariff concerns, and steady ETF buying – all while the precious metal’s fundamental backdrop remains solid amid a shifting global economic landscape.

Now might be the best time to switch out of bank hybrids

In this interview, Schroders' Helen Mason discusses investing in corporate and financial credit securities, market impacts of tariffs, opportunities for cash investments, and views on tier two and hybrid bonds.

Sponsors

Alliances

© 2025 Morningstar, Inc. All rights reserved.

Disclaimer
The data, research and opinions provided here are for information purposes; are not an offer to buy or sell a security; and are not warranted to be correct, complete or accurate. Morningstar, its affiliates, and third-party content providers are not responsible for any investment decisions, damages or losses resulting from, or related to, the data and analyses or their use. To the extent any content is general advice, it has been prepared for clients of Morningstar Australasia Pty Ltd (ABN: 95 090 665 544, AFSL: 240892), without reference to your financial objectives, situation or needs. For more information refer to our Financial Services Guide. You should consider the advice in light of these matters and if applicable, the relevant Product Disclosure Statement before making any decision to invest. Past performance does not necessarily indicate a financial product’s future performance. To obtain advice tailored to your situation, contact a professional financial adviser. Articles are current as at date of publication.
This website contains information and opinions provided by third parties. Inclusion of this information does not necessarily represent Morningstar’s positions, strategies or opinions and should not be considered an endorsement by Morningstar.