How can subordinated debt help solve the income puzzle?

01 October 2025

In a market characterised by falling cash rates, volatile dividend yields, and the phase-out of bank hybrids, where are the income opportunities for Australian investors?

Whether they’re retirees reliant on cash flow or conservative investors wary of volatility, many investors seek steady income – without eroding capital or lowering the quality of their holdings. Many still remember the challenges of generating income during a near-zero interest rate environment, and those exposed to hybrid securities are also looking for new income alternatives.

In this environment, how can investors be confident they’re optimising yield while preserving capital?

Fixed income has long been considered the defensive anchor of portfolios, providing diversification, liquidity, and a relatively reliable income stream to balance the variability of equity dividends. It’s a broad and diverse market that spans cash, bonds and hybrids through to more targeted exposures such as private credit.

Fixed income has also, until recently, been difficult to access. The standard minimum parcel size for most over-the-counter (OTC) bonds is $500,000 – out of reach for most individual investors. That’s why fixed income allocations have historically relied on managed funds and hybrid securities.

But now, ETFs are democratising access to the types of fixed income investments once only available to institutional investors – including Australian and global bonds, high yield strategies and, perhaps less well known, subordinated debt.

Balancing income and capital preservation

Fixed income investments are designed to provide income and also preserve capital. Bondholders rank ahead of shareholders if an issuer faces financial distress, and fixed income returns are generally less correlated to equities performance. This means that they can act as a stabiliser during market volatility.

The right allocation depends on investor goals – whether the priority is maximising yield, maintaining liquidity, or preserving capital.

Diversifying income with subordinated debt

Subordinated debt offers some of the highest yields in the Australian, public fixed income market, while still providing exposure to high quality issuers such as Australia’s major banks. It sits between senior bonds and equity on the risk spectrum – a higher risk tier of debt, but where exposure is to quality issuers, such as Australia’s major banks, still supported by the stability of well-capitalised financial institutions.

For some investors, this strategy could be the sweet spot between income generation and capital preservation – a typically defensive, yet high-yielding, investment.

For investors looking to optimise yields without venturing into higher-risk private credit strategies, subordinated debt could be a viable option. It has been described as the “the most genuine hybrid replacement” typically providing stable, reliable income through exposure to well-known banks and other financial institutions in Australia’s highly regulated financial markets.

Regular income is typically paid in the form of quarterly coupons, with some subordinated debt ETFs passing on income to their investors monthly. 

In the past, generally only institutional investors could access subordinated debt. In 2025, Macquarie launched the Macquarie Subordinated Debt Active ETF (ASX: MQSD), Australia’s first active ETF in this asset class, aiming to deliver monthly income.

The upside of active income

Fixed income ETFs provide diversification and liquidity, but, in our view, whether they are passive or active, really does matter. Passive fixed income ETFs track indices that tend to be weighted towards the most indebted issuers – and these issuers are not necessarily the most creditworthy.

That’s why Macquarie Asset Management’s fixed income team take an active management approach. They see investing in any type of bond as a form of lending, and carry out due diligence to ensure that they have confidence that the capital will be returned, with interest in the interim.

Active fixed income managers are at their core dynamic and, depending on the market, can adjust allocations towards higher-quality issuers and avoid those at risk for downgrades. If the credit environment deteriorates, they can increase liquidity via a range of methods not available to passive players.

They can also evaluate a much wider pool of investible securities. Macquarie’s fixed income team scrutinise the quality and repayment ability of issuers and assess which exposure they think will provide the most attractive risk-adjusted returns – across capital structure, currency, and term length.

For example, MQSD has access to the entire subordinated debt investible universe – in Australia and globally. That’s a level of diversification passive ETFs in the space cannot match, with many only tracking around 20% of securities in the subordinated debt investible universe.

Active ETFs also typically provide the same liquidity as passive ETFs – with the potential for enhanced returns, or alpha, as only active managers can take advantage of market inefficiencies.

It may surprise some investors to learn the majority of Australian major bank subordinated bonds are issued in global currencies. As Macquarie is a global asset manager, its active fund managers can scour all markets to source higher yields, including through these globally issued bonds – while delivering returns in Australian dollars and hedging currency exposure.

These strategies give active managers the opportunity to outperform their passive counterparts.

And as MQSD’s management fee of 0.29% matches the available passive subordinated debt alternatives at 0.29%, the question isn’t whether active management is worth the extra cost – but what extra can it provide for the same fee.

Cutting through the complexity

Fixed income strategies are not always simple, but active management can help investors and advisers cut through the complexity. Active managers not only respond to market shifts – they can provide confidence in exactly what – and who – you’re investing in.

Macquarie offers four fixed income active ETFs, including MQSD. Whether the goal is maximum yield, minimal risk to capital, or exposure to high quality banks and issuers, each provides the defensive and income characteristics to support a well-rounded, diversified portfolio.