This episode of Investing Compass explores the decision from APRA to make regulatory changes that a lot of investors aren't happy about. That is, to ban hybrids.

We explore how to replace hybrids in your portfolio, which can be difficult for those that are living off the income and the franking credit. The episode looks at the pros and cons of the other options that investors have. This includes dividends from common shares, bonds, a covered call strategy and annuities.

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The full transcript of the podcast can be found below:

Shani Jayamanne: Welcome to another episode of Investing Compass. Before we begin, a quick note that the information contained in this podcast is general in nature. It does not take into consideration your personal situations, circumstances or needs.

Mark LaMonica: All right, Shani, you have been busy going through the survey results. Obviously, for people that remember, we put out a survey, we do really appreciate everyone who provided all of those responses. It was great. Shani got the unfortunate task of going through them all.

Jayamanne: And compiling it all.

LaMonica: And compiling them all.

Jayamanne: There were a few insights, which is great because I think a lot of the things that we do on the podcast are quite purposeful, but it might not come across as so.

LaMonica: So you think everyone just thinks that we're just winging this?

Jayamanne: Yes.

LaMonica: It's really the quality we're going for.

Jayamanne: Yeah, exactly. So maybe we can address some of those things today, some common themes in the survey before we get started.

LaMonica: So why don't you start going through them since you were the one that went through them all.

Jayamanne: Okay, well, this part of the podcast is very off the cuff, but normally we do read off a script or read off notes. So some people did call that out and said that they could tell that we do that. But we do that on purpose. Do you want to explain why, Mark?

LaMonica: Yeah, I mean, I think more than anything else, obviously, we're very focused on making sure everything we say is accurate. One of us, won't name any names, really likes going back and looking at research and surveys. So there's a lot of very specific data that we have to get right. So that's a big one. And then the other thing is, I think we are very focused in not falling back into any jargon, not saying that we necessarily spend a lot of time saying things, saying lots of jargon in real life. But yeah, we just want to make sure that we're explaining things simply and straightforward.

Jayamanne: Agreed. And I think, you know, when we first started the podcast, one of the things that we wanted to do was become a podcast where everything was said in a very meaningful way and said very succinctly. And this gives us a way to do that. So that's the first thing.

LaMonica: Okay, that's number one.

Jayamanne: The second was third party guests on the podcast. So a few people did say that they would like to see third party guests on the podcast.

LaMonica: I'd say these were very minority opinions.

Jayamanne: Yes. But they wanted to call it out. So...

LaMonica: So I have to answer all the questions. So this is like a quiz.

Jayamanne: I did the compiling, Mark. So you got to put in some work.

LaMonica: Yeah. I mean, I think in terms of third parties, people, obviously, I think noticed that over the last year, we started trying to incorporate more voices from around Morningstar. But ultimately, everybody is third party guests. And I think we wanted to make this very much consistent and philosophically aligned to how I think the two of us see investing. And then also, of course, how Morningstar sees investing, because I think we both agree with that overall philosophy, long term and valuation focused. So yeah, I mean, I think that's my answer. I don't know if that's acceptable to you.

Jayamanne: I think that's a pretty good answer.

LaMonica: Okay. Well, there we go. On a roll. So what's my next question?

Jayamanne: All right. So the next question is, a lot of people are confused about the data and the research that we present on the podcast and what they receive through their broker.

LaMonica: And so this is a good question. So I will try to explain this without jargon and very quickly. But basically, Morningstar, if we take our equity ratings, for example, we have what's called qualitative ratings, those are the only ones we will speak about on this podcast. So that is our analysts sitting in Sydney and around the world, going through and doing a fundamental analysis on the companies in their coverage universe, and then providing an opinion. And we talk about all the different ratings they come up with. Obviously, we talk about the fair value and moat and uncertainty, capital allocation, all those different ratings. So those come from people. And then there is quantitative ratings, which come from an algorithm. So they're computers that are coming up with it. Now, unfortunately, and I'll just say this, we cover the same shares quantitatively and qualitatively. And while we'll never show you the quantitative ratings for those shares we cover in a qualitative manner on our site, and we'll never talk about them, some brokers buy those quantitative ratings and show them. So that's why there could be differences.

Jayamanne: And that's why they do jump around a lot. So if you do see it, and it's a four star stock and then a five, four, three, two, one day, that's a good way to tell that it's a quant stock.

LaMonica: Yeah. And plus we know your grasp of numbers, all of the stars.

Jayamanne: But we did actually get some really good feedback that we're going to take on and think we'll hopefully improve the podcast as well. So we had a great comment from somebody that did suggest that we do a foundational investing podcast. So something that people can go back to and listen to before they get started with us or just have a general overview of how to get started with investing.

LaMonica: Yeah. And we sat down, we came up with our first list of topics. So we'll start recording those soon. And then Shani will work her magic in whatever that platform is for podcasts. And so those are always pinned somewhere so people can go back and listen to them. You're looking at me like I'm crazy.

Jayamanne: Oh, I don't know how to do that. I'll figure it out.

LaMonica: There you go. That's like can do attitude, we appreciate around here.

Jayamanne: I think that's, I think those were the main ones.

LaMonica: Yeah. But I think one thing that's important to say is a lot of the responses were incredibly kind.

Jayamanne: Yes.

LaMonica: And we are both really, really happy. And I think Will is happy too. We'll speak for him that people are finding this useful and hopefully a little bit entertaining.

Jayamanne: Yes. And that's a very long preamble that's our longest probably that we've had.

LaMonica: So let's get into this. So Shani, today we're going to talk about some news that has come out recently. And the news is that APRA has made some regulatory changes that a lot of investors are not happy about. And that is a ban on hybrids.

Jayamanne: How are you taking the news, Mark?

LaMonica: I mean, listen, personally, I can't say that I actually care because I don't own any hybrids. But I do know that many listeners do have hybrids. So we're going to talk about what those investors can do today.

Jayamanne: And we say all the time on this podcast that any investment in your portfolio is simply a tool to do a job. And that job is to achieve your financial goals. So we're going to go through the job that hybrids do for investors and look at other ways to do the same thing.

LaMonica: Okay. And that'll be most of the podcast study. But first, we want to talk about what actually happened for investors who either haven't heard the news or don't know the details. So we're going to go back to March of 2023, Shani. And in March of 2023, Credit Suisse, the Swiss investment bank, effectively collapsed and was taken over by their rival UBS. And during this incident, investors who owned Credit Suisse hybrids lost all of their money. And the reason for that is because of what a hybrid is. So a hybrid has both debt and equity-like features. The debt part is that there's a schedule for payments to be distributed to investors, so much like a bond. The equity part is that these instruments sit below other bondholders in the capital structure, which basically just means the capital structure is a list of who's getting wiped out under scenarios like what happened with Credit Suisse. So that's what happened, Shani.

Jayamanne: All right. And this got APRA worried because what the regulator wants is a stable banking system. And part of this is confidence that banks are adequately capitalized to withstand losses, which stops runs on banks. And when APRA looked at the local hybrid market, they saw that they were primarily owned by retail investors, which made them think that if there was a panic, the reaction of the retail investors would make the situation worse.

LaMonica: So long story short, they're going away. So they will start to be phased out in 2027. And by 2032, all bank hybrids will be repaid. And right now, there are $43 billion of bank hybrids. So obviously, a lot of investors will be impacted by this. And that is what I want to focus on today. But first, if you hold hybrids now, they're not going away immediately. So continue to hold on to those securities, and the issuers will have to honor the terms in the hybrid contract. And one thing to note that while banks can no longer issue them, other companies like insurance companies can. But the problem, of course, is that banks make up the majority of the market.

Jayamanne: To understand the impact on investors means we need to understand what an investor gets out of a hybrid. Hybrids typically are issued at a margin over a benchmark rate. We can use an actual hybrid as an example, and we'll use NAB Capital Notes 8, which was issued in May. At issuance, the hybrid had a 2.6% margin over the 90-day bank bill swap rate, or BBSW.

LaMonica: Yeah, and that bank bill swap rate represents the premium that prime banks pay over the risk free rate. The prime banks are currently the big four banks, and they are appointed by the ASX. And as we're recording this, the 90-day bank bill swap rate is around 4.4%. So this is a pretty good deal for investors. So right now, investors in the NAB Capital Notes 8 are getting a roughly 7% yield. And that, of course, is much better than a term deposit. And obviously, a term deposit is very different because there is risk associated with a hybrid, just ask those Credit Suisse hybrid holders. But for an investor that doesn't believe NAB is going to get into financial trouble, that is a hard thing to give up, that 7% yield.

Jayamanne: And one huge kicker with hybrids is that they pay franking credits. And for many of the banks, they are fully franked, which further benefits investors.

LaMonica: Okay, so that gets us back to that original question that we had, Shani. How do you replace this in your portfolio if you are reliant on hybrids? And the short answer is that if you are living off that income from your hybrids and the franking credit, it is really hard. So let's walk through a couple of examples.

Jayamanne: One thing we do need to note is that because hybrids are a floating rate that yield that we quoted on the NAB security is only given the current interest rate environment. Interest rates have obviously gone up a fair amount in the last couple of years. And in a lower interest rate environment, hybrids won't appear quite as attractive.

LaMonica: Exactly. But let's go through some options. So one option is from dividends on common shares. And of course, if they're Australian shares and you're an Australian investor, you will get a franking credit on top of that. But that is just not something investors going to be able to do in a diversified portfolio, replacing that 7% plus franking credit yield. So for instance, right now, if you look at the banks, which issue so many of these hybrids, you're currently getting yields ranging from about 3.2% at CBA to a little over 5.5% for ANZ.

Jayamanne: And bonds are really the same story. Government bonds from credit-worthy countries are always going to yield less than hybrids, especially if you're taking franking credits into account. Same with most corporate bonds that have high credit ratings. You'd have to go really low down to low-rated bonds to get anywhere close to the franked yield of a hybrid. And that, of course, is very risky.

LaMonica: And even though banks will still need capital, and will instead just use bonds, so that's APRA's plan that they're going to issue bonds instead of hybrids in order to get that capital, those bonds are higher in the capital structure. And investors in theory could buy those. But the problem is we don't really have a retail-friendly bond market in Australia, so it's hard for many individual investors to buy individual bonds. And of course, a bond has no franking credit.

Jayamanne: But one thing I would think about is the opportunity for financial innovation in the period prior to hybrids going away. We obviously don't know what may happen, which is why we're focused on currently available products.

LaMonica: Yeah, so no speculation here.

Jayamanne: No.

LaMonica: We speculate about everything else, though.

Jayamanne: You speculate about everything else.

LaMonica: I speculate about everything else. So one approach, and we did talk about this before, would be a covered call strategy. And in that episode, one of the securities, one of the ETFs we talked about is the Australian Top 20 Equity Yield Maximizer Fund. That's from BetaShares with the ticker symbol YMAX. And given the price at the time of this recording, and the distributions paid over the past 12 months, the ETF is yielding over 7.5%. And guess what, Shani, you get franking credits.

Jayamanne: Love it, right? And much like a hybrid, you aren't going to get a ton of capital appreciation given the fact that the ETF invests in a covered call strategy. But for a retiree that needs income now, perhaps this is a potential substitute. But go back and listen to that episode for all the specifics on how covered calls work so you can understand the risk to that investment strategy.

LaMonica: And then for older investors, another option is an annuity, which we've also talked about on here before. So I went and I looked at rates at Challenger. And right now, on a fully inflation protected annuity, the following yields are available. So that's basically what that annuity payment is divided by how much you're putting in. So for a 65-year-old woman, 4.65%, 70-year-old woman 5.29%, 75-year-old woman 6.22% and for an 80-year-old woman 7.68%. And men get a better deal because we of course die sooner. So men get 4.93% for a 65-year-old man, 5.76% for a 70-year-old man, 6.72% for a 75-year-old man and 8.39% for an 80-year-old man. So that's an example of stats that we need to read because I have a very short memory.

Jayamanne: And so what yield do they give men your age, Mark?

LaMonica: Probably about 15-16% at this point.

Jayamanne: Now, obviously those yields are lower and there are no franking credits, but it is important to remember that hybrid yields can come down. And also the annuity offers full inflation protection. So as inflation increases naturally over time, those annuity payments will go up.

LaMonica: Yeah, and that's actually, and I will say that the ones I quoted, they offered full inflation protection. You can get higher yields if you have partial inflation protection or of course, if you have no inflation protection. So something to think about, something to think about. But we're talking about older investors and older investors who are relying on income coming from a hybrid right now. But what about younger investors, Shani?

Jayamanne: Well, in this case, it's probably less likely that an investor is holding a hybrid. But some might as a hybrid could be considered a less volatile option to shares, which plays that same role in a portfolio to lower overall volatility.

LaMonica: And in this case, if your goal is to find an investment to lower volatility, there are plenty of options, including cash and bonds. For a younger investor who's trying to build an income stream, I would suggest to focus not on the current income, but on buying shares that can raise dividends meaningfully in the years and decades to come.

Jayamanne: It is important to note about hybrids that the income doesn't grow. It can change based on interest rate levels and in a rising interest rate environment, it will get higher. But of course, it'll drop if interest rates drop.

LaMonica: Yeah. So I think, to summarize, as we said in the beginning, there aren't great substitutions for hybrids for investors out there. And I know, and I think you had a conversation with an investor today that was very disappointed that hybrids are going away. So obviously, we'll see if something comes out, that financial innovation that we talked about, something comes out that can hopefully provide investors what they're looking for. But there really aren't great substitutions. But I think this is an opportunity for everyone to step back and look at what they can live with in terms of those other options that we listed.

All right. So we made it, Shani. We talked about the survey. We talked about hybrids. We even talked about annuities. You made a joke about my age. So I think that's…

Jayamanne: Tick, tick, tick.

LaMonica: Exactly. I think that's all we need. So thank you guys very much for listening. We, of course, would appreciate any emails. My email address is in the show notes and, of course, any comments or ratings in your podcast app.

(Disclaimer: Any advice in this podcast is general advice or regulated financial advice under New Zealand law prepared by Morningstar Australasia Proprietary Limited and/or Morningstar Research Limited without reference to your financial objectives, situations or needs. You should consider the advice in light of these matters and any relevant product disclosure statement before making any decision to invest. To obtain advice for your own situation, contact a financial advisor.)

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