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19 February 2025
In this guide, we will explore:
Also known as Tier 2 capital, subordinated debt securities rank below senior debt in terms of repayment priority in the event of insolvency of a company. However, subordinated debt takes priority claim of cash flows and assets over hybrid securities and equities in the event of a default.
To determine the potential risk or return of any security investment, it’s important to understand where the security sits within the issuer’s capital structure. The higher a security ranks in the capital structure, the lower the risk of a default event and the higher the level of protection compared to other securities further down the capital structure.
For example, here’s a typical capital structure of a financial institution. Most banks and insurers are required to hold a certain amount of capital, which they do through a combination of equities, debt, and deposit holdings.
Subordinated bonds are typically unsecured, meaning they are not backed by specific assets. Their value is tied to the overall creditworthiness of the bond issuer.
Let’s take a closer look at the different securities making up a financial institution’s capital structure.
The claims of subordinated debt holders rank below that of senior bondholders or depositors. That means if the issuer were to default, subordinated bondholders will only be paid after all obligations to higher ranking creditors are paid. As a result, subordinated bonds generally pay higher interest than senior bonds.
Despite ranking lower on the capital structure hierarchy, subordinated debt has many of the same higher-quality features as senior bonds. They both offer non-discretionary coupons, so interest payments must be made, and have a clearly defined maturity date at which principal must be repaid.
What differentiates subordinated bonds is their ‘loss absorbing’ feature. Subordinated bonds form part of the regulatory capital that banks are required to hold to protect depositors and policyholders from unexpected losses. This means in the event of severe crisis, which the regulator deems a bank to no longer be viable, interest and capital payments owing to subordinated bondholders can be delayed, converted to equity potentially at a significantly lower value than the principal amount or in the worst case written off. To compensate for this risk, subordinated debt can offer a higher yield than senior debt and deposits.
| Senior Debt | Subordinated Debt (Tier 2) |
Hybrids (Tier 1) |
| Seniority (ranking) | Above subordinated debt, hybrids and equities | Above hybrids and equities | Above equities |
| Payment discretion | No discretion – coupons must be paid | No discretion – coupons must be paid | Banks have discretion in making coupon payments |
| Maturity date | Fixed maturity date | Fixed maturity date | No maturity date |
| Franking | No | No | Yes |
| Missed coupon payments | Accumulate as debt | Accumulate as debt | Do not accumulate as debt |
| Common equity trigger event | Will not be converted or written off | Will not be converted or written off | May be converted or written off |
| Non-viability trigger event | Will not be converted or written off | May be converted or written off | May be converted or written off |
As subordinated bonds rank higher in the capital structure, they provide more protection and lower capital risk than hybrids and equities. They are more akin to debt: interest payments must be met, and the principal repaid at maturity.
Investors have used hybrid securities for decades as a way to access regular floating rate income payments and franking credits.
Both subordinated debt and hybrids have a ‘loss absorbing’ feature as describe above, however in addition to this, hybrid securities also have a capital trigger. This trigger defines a minimum capital threshold of the bond issuer below which these instruments will be immediately written down or converted to equity, resulting in greater capital risk.
Hybrid securities are also listed, making them more accessible for advised and retail investors. However, this doesn’t always translate into greater liquidity, as few institutional players invest in hybrid markets.
With APRA’s requirement to phase out the new issuance of hybrids (or additional tier 1 instruments) by January 2027, banks and issuers are likely to replace hybrids with other forms of capital – like subordinated debt.
Subordinated debt is a liquid investment, but has been harder to access for most investors, outside of institutional investors. Now, investors can gain easier exposure to actively managed subordinated debt via exchange traded funds on stock exchanges, like the ASX.
APRA requires major Australian banks to hold a certain amount of regulatory capital to protect depositors from unforeseen losses. This also limits the potential need for taxpayer money to bail out a failing institution, as we saw in the US and Europe during the global financial crisis. Subordinated debt acts as this buffer. It can absorb potential losses in the event of financial stress, by converting to equities and thereby lowering the debt burden of the company.
Recent regulatory changes requiring hybrids to be phased out will see subordinated debt form an increasingly significant part of the Australian fixed income universe. While it generally offers a higher yield than senior debt or cash, it will become the lowest ranked debt instrument in the capital structure.
For investors with holdings of cash, deposits and senior bonds who are willing to take more credit risk, subordinated debt issued by well-known and well capitalised Australian financial institutions can provide access to potentially higher yielding opportunities.
On the other hand, for investors with holdings in high-yielding hybrids or shares who are seeking to reduce credit risk, subordinated debt can play an important defensive role in a diversified portfolio.
Until recently, only institutional investors could access subordinated debt securities. Now, investors can gain actively managed exposure to subordinated debt via exchange traded funds, including the Macquarie Subordinated Debt Active ETF.
Macquarie Subordinated Debt Active ETF (ASX:MQSD) seeks to deliver above Ausbond Bank Bill Index returns over a rolling three-year basis (before fees) and regular income. The Fund will primarily invest in subordinated bonds issued by Australian entities or denominated in Australian dollars, with significant exposure expected to be to those issued by Australian major banks and other financial institutions. It is managed by one of Australia’s largest and most experienced active fixed income managers, Macquarie Asset Management.
For investors looking to replace their hybrid exposure with similar risk and return characteristics, investing in an actively managed subordinated debt ETF is now as simple as buying and selling shares on the stock exchange.
Common equity trigger: A minimum capital threshold of an issuer, below which the relevant tier 1 instrument is required to be written down or converted to shares at a value potentially significantly below the principal amount.
Cumulative coupon: A coupon payment that, if not paid by the issuer, will accumulate and must be paid in the future.
Defined maturity: A predefined date when the principal amount of a bond becomes due and is payable to bondholders.
Discretionary coupon: Coupon payments made at the issuer’s discretion.
Loss absorbing (point of non-viability): Power granted to the prudential regulator to cause the instrument to be written down or converted to shares at a value potentially significantly below the principal amount. This only occurs in the event of a severe crisis where the regulator deems the bank or issuer no longer viable.
Non-cumulative coupon: Coupon that will not accumulate to be paid in future distributions.
Non-discretionary coupon: A coupon that, if unpaid, would constitute a default event.
Optional call date: A date prior to maturity when the issuer has the option to repay the debt early.
Partial Government Guarantee: The Australian government guarantees up to $250,000 deposited with Australian incorporated authorised deposit-taking institutions.
All investments carry risk. Different investments carry different levels of risk, depending on the investment strategy and the underlying investments. Generally, the higher the potential return of an investment, the greater the risk (including the potential for loss and unit price variability over the short term). The risks of investing in this Fund include:
Investment risk: The Fund seeks to generate higher income returns than traditional cash investments. The risk of an investment in the Fund is higher than an investment in a typical bank account or term deposit. Amounts distributed to unitholders may fluctuate, as may the Fund’s NAV unit price, by material amounts over short periods.
Manager risk: There is no guarantee that the Fund will achieve its performance objectives, produce returns that are positive, or compare favourably against its peers, or that the strategies or models used by the Investment Manager will produce favourable outcomes.
Income securities risk: The Fund may have exposure to a range of income securities. The value of these securities may fall, for example due to market volatility, interest rate movements, perceptions of credit quality, supply and demand pressures, a change to the reference rate used to set the value of interest payments, market sentiment, or issuer default.
More information on the risks of investing in the Fund is contained in the Product Disclosure Statement for the Fund, which should be considered before deciding to invest in the Fund.
Important information
The Target Market Determination (TMD), available at macquarie.com/mam/tmd, includes a description of the class of consumers for whom the Fund is likely to be consistent with their objectives, financial situation and needs.