As one door closes for yield-hungry fixed income investors, others are opening

By Chris Viol, Executive Manager Fixed Income, Commonwealth Private

The hunt for yield has long been part of investors’ wealth creation and preservation strategies. After all, dividends, coupons, distributions and other income streams are key drivers of total returns, tending to work harder in portfolios than short-term asset price movements.

After the significant rate hiking cycle that began in 2021-22, and with the Reserve Bank of Australia (RBA) now expected to hold rates steady, fixed income investors face a higher-for-longer rate environment. It’s delivering cyclically elevated yields even as credit spreads remain historically low, with all-in yields notably higher than investors received five or six years ago.

While the phrase ‘spreads are tight, but the yield is right’ neatly captures the status quo, two developments complicate the outlook for yield-focused fixed interest investors. The first is that many term deposit investors are seeking higher yielding assets that offer defensive qualities. The second is the phase-out of domestic bank hybrids, removing a source of historically strong running yields, albeit at the riskier end of the fixed income investment spectrum.

In simple terms, to achieve predictable, risk-adjusted yield over cash and term deposit rates, investors must now look to alternative fixed income investments and rethink their allocation decisions.

What will fill the bank hybrid void?

With domestic bank hybrids progressively vanishing over the next seven years, the question then becomes where are banks turning for capital and investors for dependable yield?

This shift in the fixed income landscape followed APRA’s decision to phase out Tier 1 regulatory capital (AT1s) for domestic banks by 2032. That’s the capital banks use to absorb losses in extremely tough times, typically raised through ASX-listed hybrids. Instead, larger banks will rely on Tier 2 capital, known as subordinated debt. Tier 2 debt is higher up the capital structure than AT1, meaning investors are more likely to be repaid if the issuing bank experiences severe stress.

Following APRA’s announcement, issuance and trading activity for the ASX-listed hybrid market has dried up. Commonwealth Private’s research indicates around $15 billion in ASX-listed financial AT1 securities are likely to be repaid between 2025 and 2027. This suggests a wave of capital will be exiting hybrids and seeking alternative fixed income assets that play a similar role in portfolios.

The Tier 2 subordinated debt market has grown enormously since 2019, when banks were required by APRA to start holding more loss-absorbing capital. This Tier 2 issuance trajectory is set to continue and despite subordinated debt investors receiving lower coupons given the lower risk profile compared to hybrids, it remains a source of enhanced yield.

The case for diversified actively managed fixed income credit portfolios

Investors have several options when searching for yield, and actively managed fixed income funds that adjust their measured interest rate and credit exposures can be particularly effective. These managers balance medium-term return targets with capital objectives, allowing them more flexibility. When market conditions become difficult, their focus can switch from pursuing short-term returns to reducing the impact of market volatility on portfolio performance.

An absolute return approach focused on risk-adjusted outcomes can help deliver capital stability and smoother performance in volatile markets. This differs from assets such as ETFs or single name bonds, which can provide beneficial market exposure or fixed income streams, but generally have less capacity to adjust positioning as market conditions change.

When assessing fixed income managers and funds, a robust evaluation framework is essential. For example, during the investment selection process for the Yield Model, we looked for a range of attributes. This included investment-grade-based portfolios, a moderate exposure to higher-yielding assets, multi-sector strategies, measured interest rate and credit exposures, acceptable liquidity, and a solid track record of risk-adjusted returns.

This level of scrutiny should apply equally to other yield alternatives. Further out the risk curve, listed Investment Trusts (LITs) and listed notes also offer returns comparable to bank hybrids, but with portfolios predominantly invested in private credit assets.

It’s worth remembering that when allocating to private credit managers, examining performance, diversification, portfolio composition, underlying liquidity, and risk management is arguably even more important. That’s due to their higher risk-return proposition compared to liquid, mainly investment-grade fixed income portfolios.

Above all, whether you are a bank hybrid investor looking to reinvest capital or simply looking to enhance yield with capital stability, it’s essential to start with clear risk-return parameters and stay disciplined and discerning.

To learn more about how Commonwealth Private can help you with your private banking needs visit commbank.com.au/private

The information in this article has been prepared without taking into account any of your objectives, your financial situation, or your needs. You should consider whether the information is appropriate for you, having regard to your objectives, financial situation and needs before you act on the information. You are responsible for your own investment decisions, including whether to acquire, hold, or dispose of any investment opportunities. The information in this article has been prepared by Commonwealth Private Limited ABN 30 125 238 039 AFSL 314018 (Commonwealth Private), a wholly owned non-guaranteed subsidiary of the Commonwealth Bank of Australia ABN 48 123 123 124 AFSL and Australian credit licence 234945 (Commonwealth Bank). Commonwealth Private is not an authorised deposit-taking institution for the purposes of the Banking Act 1959 (Cth). Its obligations do not represent deposits or other liabilities of the Commonwealth Bank. While care has been taken in the preparation of this article, no liability is accepted by Commonwealth Private, its related entities, agents and employees for any loss arising from reliance on its content.