The Portfolio Hidden Inside a Bank Hybrid
As Australia’s bank hybrids are phased out, the capital comes back with several plausible destinations. Making their income figures comparable is only the start of deciding what belongs in the portfolio next.
By the team at Banyantree Investment Group
Adapted from analysis first shared in our Monthly Investment Series of 28 July 2026.
A bank hybrid can leave a portfolio as one security and return as a bond fund, a credit fund and a cash allocation. The income figure can look almost unchanged.
APRA’s revised bank-capital framework begins on 1 January 2027 and removes Additional Tier 1 capital from the prudential framework. Existing securities keep their legal terms, including their subordination, while the outstanding bank AT1 stock is phased out by 2032. Calls and redemptions will still occur issue by issue under the terms of each instrument. The reform is settled, but each holding follows its own timetable.¹
On a portfolio statement, the old holding looked simple: a familiar bank security trading on the ASX and paying a regular distribution.
Representative Australian bank capital notes have paid a floating distribution based on a short-term bank bill rate plus a fixed margin. With full franking, the cash payment was adjusted for company tax and the holder received a franking credit. The value of that credit depended on the holder’s tax position and eligibility.
The note also sat deep in the bank’s capital structure. AT1 distributions were discretionary. The instrument was generally permanent but callable, and could absorb losses through conversion or write-off in severe stress. The first call date mattered greatly in practice, although the issuer held the option and had to meet conditions including regulatory approval.²
In ordinary markets, the security could feel shorter and safer than its legal form suggested. The distribution reset with short-term rates, the issuer remained profitable and convention supported the expected call. The ASX listing supplied a visible price and a route to sell. None of those features changed the note’s rank when the bank itself came under pressure.
One payment carried several exposures. It reflected the cash rate, the bank’s credit spread, the holder’s place in the capital structure and, for some investors, the value of franking. The expected call influenced how long the capital appeared to be committed. Exchange trading shaped the investor’s sense of liquidity.
This is the portfolio hidden inside the hybrid. The wrapper made one line item out of exposures that have to be chosen separately once the security leaves.
Suppose A$100 in a fully franked capital note pays A$5.25 in cash over a year. At a 30% company tax rate, the attached franking credit is A$2.25. An eligible holder able to use the credit may describe the grossed-up income as A$7.50, or 7.5%.
Now suppose A$100 in a bond portfolio also shows a 7.5% yield to maturity.
The figures match. The cash does not.
The first 7.5% consists of A$5.25 received in cash and A$2.25 of investor-dependent tax value. The second estimates the annual return embedded in the portfolio’s current securities if contractual payments are made and the holdings are carried to maturity, before fees and tax. Part of that return may arrive through price accretion rather than distribution. The portfolio may trade before those securities mature. Defaults, prepayments and hedging can alter the realised outcome.
Both figures can be calculated correctly and still answer different questions.³
No competent institutional process should stop there. It would restate both columns using common assumptions for tax, fees, cash distributions, expected total return and holding period. The arithmetic would become comparable.
The portfolios would not.
Even if both columns produced the same expected after-tax return, the bond portfolio could carry duration that the floating-rate hybrid did not. It might distribute less cash than its yield to maturity suggests. It could diversify away from one Australian bank while adding foreign credit, currency hedging and manager risk. The calculation can align the expected return. It cannot make the conditions producing that return identical.
That is the boundary between measurement and allocation. Normalising the numbers removes a category error. It does not decide which function of the old security should survive.
Before calling anything a replacement, the portfolio has to fix the unit of comparison: quarterly cash, after-tax return, liquidity, sensitivity to interest rates or behaviour under credit stress. One successor rarely reproduces all of them.
The immediate question is where the money should go. The more useful question is which function of the old holding deserves to survive, and what new failure condition comes with it.
Bank Tier 2 debt preserves exposure to the issuer and part of the credit spread. It ranks above AT1, pays mandatory coupons and has a stated maturity of at least 5 years under APRA’s framework. Franking generally disappears. The portfolio has exchanged AT1’s loss-absorbing position and call structure for a higher-ranking contractual claim with a clearer term.²
A diversified global bond allocation addresses concentration rather than replication. It can spread exposure across governments, companies, countries and sectors while introducing duration, securitised credit, foreign markets, currency hedging and active manager decisions. Return may come from carry, falling government yields, tighter credit spreads or price gains as bonds approach maturity. The old hybrid relied on a different mix: a floating, franked claim on one Australian bank.
Private credit can restore part of the income through loans that trade less often. Valuations depend more heavily on policy and manager judgement, and exits may take time. Covenants, collateral and control of a workout can improve the lender’s position. The borrower’s business remains just as cyclical. ASIC’s surveillance has focused on the risk that infrequent price discovery allows reported valuations to lag economic deterioration, and on the need for redemption terms to match the liquidity of the underlying loans.⁴
Enhanced cash keeps more of the short-rate exposure and day-to-day liquidity. That liquidity usually comes with a lower expected return. It can fund withdrawals or rebalancing without forcing a sale from the longer-duration or less liquid sleeves.
Each allocation preserves one feature of the hybrid and changes another. The new portfolio may be better diversified, but its result now runs through several markets, valuation processes and, often, managers.
Rising policy rates lift the income on floating-rate exposures, including the old hybrid, while longer-duration bonds can fall in price. A sharp fall in rates produces the reverse pattern: cash and floating-rate income decline, while duration may add capital gains. The same bond allocation can therefore disappoint a portfolio seeking current cash and help one seeking protection from a slowdown.
A recession separates the credit engines. High-quality government bonds may gain as private borrowers face weaker earnings and harder refinancing. Bank Tier 2 still carries the bank, though from a stronger position than AT1. A diversified bond portfolio may reduce exposure to a bank-specific event, while private credit moves more of the result into underwriting, recoveries, valuation practice and the terms on which investors can withdraw.
The liquidity promise changes too. A listed security provides a price every day, including on days when the price is poor. An open-ended private-credit vehicle may report a steadier value while using notice periods, queues or other tools to align withdrawals with assets that cannot be sold quickly. Enhanced cash sacrifices income to keep more capital available.
Similar expected returns can lead to different losses, at different times, for different reasons.
For a portfolio funding regular spending, the relevant comparison is cash available after fees and tax, paid when the liability falls due. A high yield to maturity does not guarantee an equally high distribution. Total return may arrive later through the pull to par or through market gains, neither of which pays this quarter’s withdrawal unless a security is sold.
A portfolio using the hybrid as floating-rate exposure faces a different comparison. Replacing it with duration changes the portfolio’s response to inflation and central-bank policy. The successor can be better diversified and still fail the original interest-rate role.
Franking creates a holder-specific test. A pre-tax comparison is incomplete where franking contributed materially to the old result. The same capital note never produced one universal after-tax return because the value of its credits varied with the holder.
For a defensive allocation, stress behaviour matters more than observed price stability in ordinary markets. Infrequent marks can smooth the reported path without making a private asset safer. Daily pricing supplies a current price; the portfolio cannot assume yesterday’s price is still available.
A multi-sleeve replacement also uses more governance capacity. One capital note required analysis of the issuer, its terms and the expected call. Several funds may reduce security concentration while adding manager selection, currency hedging, valuation policies, redemption terms and rebalancing. More diversified assets can still require more decisions to keep the portfolio coherent.
The strongest objection is that none of this should trouble a capable allocator.
A sound process would put every return measure on the same basis, reject any false comparison and redeploy the capital according to the portfolio’s existing objectives. It would not regard the former hybrid yield as a target that must be recreated. On this view, the portfolio hidden inside the hybrid is simply factor decomposition with a new name.
The objection is right about the arithmetic. It is also right that exact replication need not be the objective.
It does not finish the decision.
A common-basis calculation can estimate what each alternative is expected to earn. It cannot choose whether spendable income matters more than capital protection, whether daily liquidity is worth a lower return, or whether the portfolio has the governance capacity to add another manager and another valuation process. Those are portfolio choices, not missing cells in the spreadsheet.
And declining to reproduce the hybrid still requires a redesign. A lower-yielding successor may improve the portfolio by offering a stronger claim, more reliable liquidity or broader diversification. More government duration may improve one portfolio. Another may already hold enough duration and accept less liquidity for additional credit income. The liabilities and risks elsewhere determine the answer.
The point is narrower than saying investors routinely confuse grossed-up yield with yield to maturity. The 2 figures show only the first layer of the problem. Once they have been normalised, the investor still has to decide which old functions to preserve and which new risks to accept.
A portfolio yielding less than the hybrid may have bought something valuable with the difference. A portfolio matching the old figure may have recreated the income through risks the investor did not previously carry or cannot govern well. Both are redesigns, whatever the report calls them.
The old holding and the successor become comparable only when both are described on the same four dimensions.
The first is spendable cash after fees and tax, with the timing of each payment made explicit. The second is the loss path: which conditions produce a temporary mark, which can produce permanent impairment, and whether several sleeves are likely to weaken together. The third is usable liquidity, measured by how much capital can be raised within the period the portfolio actually has, and at what price. The fourth is governance, including the number of managers, valuation policies, hedges and rebalancing decisions the construction requires.
Those dimensions expose the choices hidden by the headline yield without pretending that one successor suits every portfolio.
Call and redemption schedules determine when capital returns, while spreads on remaining hybrids, Tier 2 debt, high-quality bonds and cash show the price attached to each rank and term. Cash distributions can then be compared with quoted yields to maturity. Drawdowns and dealing terms reveal how much liquidity survives when spreads widen; in private credit, non-accruals, restructurings, valuation changes and recovery values distinguish sound underwriting from slow recognition.
One calm year would settle little.
The argument weakens where successor portfolios deliver comparable after-tax cash through a rates and credit cycle while maintaining the liquidity and drawdown behaviour assigned to the old holding, without creating a governance burden that changes the economics. It strengthens where an income target draws capital towards more duration, deeper subordination or less liquidity, particularly when the change is hidden by a familiar percentage at the top of the report.
Eventually a redemption notice arrives and the security becomes cash. The convenience of the old wrapper disappears with it. The portfolio then chooses, separately, the interest-rate exposure, the credit claim, the liquidity, the tax treatment and the governance needed to hold them together.
The final redemption will look like cash returning. The replacement is the set of risks chosen to earn the next dollar of income.
General information only. Not personal advice. Past performance is not indicative of future performance. Examples are illustrative. This material is intended for wholesale and professional investors.
Notes
1. Australian Prudential Regulation Authority, “APRA finalises changes to phase out Additional Tier 1 capital instruments”, 4 December 2025; and “Finalising the removal of Additional Tier 1 capital”, 4 December 2025. The first confirms the 2032 phase-out and that existing legal terms, including subordination, remain unchanged during the transition; the second confirms that the revised prudential standards and guidance take effect on 1 January 2027.
2. Australian Prudential Regulation Authority, “A more effective capital framework for a crisis”, 10 September 2024, Table 1; Commonwealth Bank of Australia, CommBank PERLS XV Capital Notes Prospectus, 26 October 2022, pp. 12, 19, 25–30 and 112–18. APRA describes AT1 as generally permanent but callable, with discretionary distributions and loss absorption, and Tier 2 as senior to AT1, with mandatory coupons and a maturity of at least five years. The CBA prospectus illustrates a floating distribution based on BBSW plus a margin, adjusted for the corporate tax rate, with redemption subject to APRA’s prior written approval.
3. Income Tax Assessment Act 1997 (Cth), s 207-20; Commonwealth Bank of Australia, CommBank PERLS XV Capital Notes Prospectus, 26 October 2022, pp. 25–27. The A$5.25 cash, A$2.25 franking-credit and 7.5% grossed-up example assumes full franking and a 30% corporate tax rate. The 7.5% bond-portfolio yield to maturity is also illustrative; neither figure states a current security, fund or portfolio return.
4. Australian Securities and Investments Commission, REP 820 Private credit surveillance report: Retail and wholesale surveillance, released 5 November 2025. See the report’s findings on valuation practices, limited price discovery, liquidity management and redemption arrangements in private credit funds.
