With Additional Tier 1 (AT1) capital instruments such as hybrids on the way out, income-oriented investors who want continued exposure to Australian bank capital are looking for alternative investments. Financials’ Tier 2 capital represents that, but it has traditionally been a wholesale-only ‘over-the-counter’ (OTC) market, with large ticket sizes and minimum investments effectively locking-out retail investors.
The Seed Financial Income Fund Active ETF (ASX ticker SFIF) aims to redress this. It is a listed version of the firm’s unlisted Financial Income Fund (FIF), which invests in fixed-income securities issued by APRA-regulated entities, and which recently notched its ten-year anniversary. Over that period, the Financial Income Fund has delivered investors a net return of 6.45 per cent a year, outperforming the hybrid market benchmark, the Solactive Hybrid Index, by more than 1.6 percentage points a year. This was achieved during a period when the RBA cash rate averaged just 1.95 per cent a year.
“Investors have told us they like the fund, but stockbroking clients and wealth management groups have told us that they have clients that like listed investments – you’ve had an unlisted fund for ten years, is there any chance we could have a listed vehicle? That’s usually done through an active ETF, and that’s how it came about,” said Nicholas Chaplin, director and portfolio manager at Seed Funds Management, in an interview.
Three-quarters of the portfolio is invested in Tier 2 capital instruments and senior debt. “The history of this fund since 2015 is that it gives investors exposure to hybrids from banks, insurers and non-bank financials – there are no corporate issues in the portfolio – and unlisted subordinated notes and senior bonds issued by top-quality banks and insurers in Australia,” said Chaplin.
“The reason for that is that we like the over-arching prudential regulation of APRA, which has done a tremendous job on the banking industry in Australia – I think it’s the best-regulated banking industry in the world. The Australian banks are the best-capitalised banks in the world, with good liquidity and good management. That’s what you’re getting with this fund. This is an Australian portfolio, not a foreign currency investment; we don’t even buy ‘Kangaroo bond issues (international issuers issuing Australian dollar-denominated bonds), because we trust Australia so much,” he said.
Chaplin sees APRA’s phase-out decision opening up greater opportunities for retail investors in Tier 2 capital, which has effectively been a wholesale-only market.
“The hybrid phase-out is going to take six years, but they’re going to get less and less liquid. I’ve always envisaged that by 2032, when there’s only one hybrid instrument out there on the ASX, there’ll be one person holding all of it,” he said. “The banks are being asked to phase-into subordinated notes as they phase-out of hybrids; that means we’ll see an increase in issuance, which will place upward pressure on margins, because there’ll be a lot more supply.”
Some of that issuance will go offshore, he said – “the banks don’t mind diversifying their currency, diversifying their investor base” – but it will only represent about 25 per cent of the issuance of Tier 2, which is a form of subordinated note regulated by APRA. “The rest will be issued in Australia. We’re on top of that, we’ll be looking at that and we’re going to take advantage of it, and give investors in our fund access to those OTC instruments. You’re going to see a natural move from hybrids to subordinated notes, by the banks and the insurers in Australia, and we’ll look to take advantage of that.”
Chaplin expects “somewhere between $25 billion and $30 billion of extra issuance” over the next five to six years by the banks and insurers. “The insurers can still issue hybrids, but they only represent about 15 per cent of the market. So, we will still to a large extent be focused on banks, and they’ll be issuing subordinated notes. And as balance sheets grow, we’ll see more senior bond issuance from banks and insurers, too.”
Chaplin said it is extremely difficult for retail investors to invest in OTC instruments like subordinated notes and senior bonds, so easy access to these is appealing. “If we can bundle up the listed hybrids with the unlisted instruments, investors can get easy access to that,” he says. “This fund represents a rare opportunity for retail investors to access professionally managed fixed income exposure through a transparent and accessible ASX-quoted structure, that offers intra-day liquidity and monthly income distributions. It suits investors looking for regular income.”
Part of the good reception the fund has encountered, he said, is that investors are looking for defensive protection. “The market is getting a little bit more jittery, people are getting concerned about the quality of management, and I think the ten-year history in this case speaks for itself.
“Behind that ten-year history is 30 years-plus working in finance, the team at Seed has an extensive history looking at these kinds of instruments and managing them. That kind of defensive nature appeals to the investors. We’re getting a lot of interest from high-net-worth individuals, from self-managed superannuation funds (SMSFs), all the way up to corporations and family offices,” Chaplin said.