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Wednesday 02 November 2022 by Jessica Rusit Opinion

Less risk, similar returns - Tier 2 OTC bonds better value than listed Tier 1 hybrids

New Tier 1 listed hybrid issuance has highlighted the relative value offered by Tier 2 subordinated notes, demonstrating a better risk/reward proposition. Here we look at why OTC Tier 2 notes offer significantly better value compared to Tier 1 listed hybrids.


While ardent hybrid investors would have invested in the recent new ASX-listed Additional Tier 1 bank issued hybrids, others are puzzled by the broadly identical issue margins compared to those on offer in the more senior-ranking over-the-counter (OTC) Tier 2 space. It’s a disconnect that market commentators from both The Australian and Australian Financial Review, among others, have reported on.

Here we explore the differences between the two types of instruments and ultimately why we (and many others) see better value Tier 2 notes offer.

Tier 2 notes safer than Tier 1 hybrids

While both Additional Tier 1 hybrids and Tier 2 Capital notes are considered fixed income instruments, hybrids (as the name suggests) also have equity like features, making them inherently riskier. The periodic payments on listed hybrids are at the bank’s discretion, providing no certainty of income, and there is no obligation that skipped payments must be repaid at a later date. Furthermore, Tier 1 hybrids automatically convert into equity if a bank’s common equity tier 1 (CET1) ratio drops to 5.125%.

On the other hand, periodic payments on Tier 2 securities are a legal obligation and any missed payments accumulate until payment is made.

Listed hybrids are perpetual, with no fixed maturity date and they rank ahead only of ordinary shares but behind all other creditors (including senior debt and Tier 2 investors) in the event of insolvency. This is illustrated in the chart below, showing subordinated debt (Tier 2) ranking senior to hybrids.

Due to the higher inherent risk of these equity-like features, listed hybrids should provide a higher rate of return compared to regular debt securities. But with recent hybrid issuance pricing on the richer side, it has become evident investors are not being compensated for the additional risks.

Better value in Tier 2 notes

The recent Commonwealth Bank of Australia (CBA) ASX-listed Tier 1 hybrid, PERLS XV (ASX:CBAPL), priced at a tight margin of 2.85% over the bank bill swap rate (BBSW). Based on where the current 3month BBSW is trading, this equates to an initial distribution of around 5.92%, at time of writing.

We note also that the hybrid distribution is fully franked, and as such investors would expect to receive only 70% of the total in cash, relying on the remaining 30% to come via a franking credit accessed through their tax return. Tier 2 bonds pay 100% of their coupons in cash.

The margin is at the skinnier end of CBA’s hybrid issuance, as shown in the chart below. CBA launched a PERLS XIV (ASX:CBAPK) listed hybrid in March this year, at a spread of 2.75%. At only 10bp wider, the recent PERLS XV issue doesn’t seem to reflect the significant widening in credit spreads since March, when the cash rate was 0.10%, jumping to 2.60% at the time of its recent issuance By comparison, CBA issued a OTC Tier 2 note in April at a spread of 1.90% and yet, its most recent Tier 2 issue in late October priced at a spread of 2.70%.

While the pricing on the CBA PERLS XV is out of line compared to its existing issuance, it’s also more expensive compared to other lower risk OTC Tier 2 issuance. Dutch bank and financial services company, Rabobank, recently issued a new OTC Tier 2 note, at a wider margin of 2.95% over BBSW or looking at the fixed-rate version of the bond, at a fixed return of 7.074%.

Rabobank’s Tier 2 notes are 4 years shorter in tenor and are rated two notches higher in credit rating than CBA’s PERLS XV. Rating agency S&P award all Aussie bank issued hybrids a BBB- credit rating, whereas Rabobank’s Tier 2 notes carry a BBB+ credit rating from the same agency, reflecting the lower risk compared to the Tier1 listed hybrids.

OTC fixed income investors have been able to achieve more compelling returns from recent Tier 2 transactions, including Challenger Life’s notes that issued at a margin of 3.55%, providing a fixed return of 7.186% (noting this issue is rated BBB, one notch higher than the PERLS series).

Recent Tier 2 issuance also looks attractive when compared to historical averages in the Tier 2 space. The average issue margin on existing Tier 2 notes issued over the past five years is 2.19%, showing the premium in spreads currently on offer.

As mentioned above, OTC Tier 2 notes are also ideal for investors seeking income, with the coupon paid in cash in full, rather than the distribution split between cash and franking credits; as is the case for listed hybrids. Rather than waiting for end of year tax to utilise the franking credits, investors have immediate access to the periodic payments Tier 2 notes provide.


While most investors are more familiar with listed hybrids, Tier 2 issuance in the OTC fixed income market is just as easy and accessible (and arguably lower risk). Investors are able to invest in a minimum $10,000 face value parcel of Tier 2 notes, as part of an overall fixed income portfolio, where they hold direct ownership over the investment, as they would a listed-hybrid exposure.

Furthermore, with similar or even better returns on offer and a lower risk investment, Tier 2 notes provide a more attractive investment option compared to Additional Tier 1 listed hybrids.