How to earn more from the Big Four

This piece was authored by Ankit Shrestha, Assistant Portfolio Manager at Betashares.

As Australia’s bank hybrid market sunsets over the next few years, income investors are facing a gap in their portfolios.

The good news? There is another asset which can fill this gap, one many investors may not have considered: Tier 2 subordinated debt. These bonds offer attractive yields with 5-years-to-call Big 4 Tier 2 bank bonds typically yielding 100 to 200 basis points (bps) more than the RBA cash rate. For income investors seeking both yield and more stability than bank hybrids, subordinated debt offers a compelling proposition.

But not all subordinated debt is created equally, and understanding the options in the asset class is crucial.

Introducing the bank capital structure

To understand subordinated debt, we first need to look at the bank capital structure itself. Put simply, the bank capital structure determines who gets paid and in what order should a financial institution go insolvent. As an investor moves from the top of the capital structure downwards, returns and yields typically increase as each level acts as a line of defence for the levels above it. The more risk an investor takes by the assets they choose the more yield they could receive – as long as the institution does not go bust.

As the diagram below shows, subordinated debt sits in the fourth layer of the capital structure, above hybrids and shares but well below secured debt and deposits. Most retail investors know hybrids and shares well, but subordinated debt remains less familiar.

All about subordinated debt

Australian investors are increasingly turning to subordinated bonds, drawn by attractive yields relative to senior debt, strong credit quality, good liquidity, and upcoming regulatory changes. This final point is especially relevant given that from January 2027, APRA is phasing out hybrid securities (sometimes called AT1 capital) and forcing banks to meet capital requirements through other means. Tier 2 subordinated debt is one of those means. We have written extensively about the end of the hybrids market which you can read about here.

These bonds can also be fixed or floating rate, meaning the interest rates on these bonds can either be the same for the entire life of the bond (fixed) or may change over time (floating). The Betashares Australian Major Bank Subordinated Debt ETF (ASX: BSUB) offers access to this space through investing in floating rate bonds, which may assist in minimising interest rate risk.

What investors need to consider about subordinated debt

Despite ranking lower on the capital structure hierarchy, subordinated debt has many of the same higher-quality features as senior bonds. They both offer interest payments and have a clearly defined maturity date at which principal must be repaid.

Having said this, subordinated debt income does not come with the benefit of franking (whereas hybrids do). In addition, should a bank become no longer viable, interest and capital payments owing to subordinated debtholders can be written off or converted to equity, leaving the investor significantly worse off than when they started. The compensation for this risk is the higher yield that subordinated debt tends to offer.

Finally, it's worth noting that subordinated debt is typically unsecured, meaning it is not backed by specific assets. Its value depends primarily on the issuer's overall creditworthiness (in this case, Australia's Big Four banks).

Where does it fit in an investor’s portfolio?

For income-focused investors concerned by the phasing out of bank hybrids, subordinated debt offers a strategic middle ground.

While this transition may feel disruptive, the end of one asset class offers a chance for smart investors to explore high-quality credit income that was once difficult for retail investors to access efficiently.

For balanced portfolios seeking income while remaining risk-aware, this transparent and cost-effective structure offers a compelling way to maintain bank exposure while potentially reducing volatility compared to traditional hybrid holdings. While it may not exactly match the yields that bank hybrids have offered, it may serve as the next best option for retail investors given the circumstances, not to mention the improved credit quality and lower risk when compared to hybrids.

Why access Tier 2 debt from the Big Four alone?

BSUB provides efficient exposure to Tier 2 subordinated bonds from Australia's Big Four banks – institutions recognised around the world for their credibility as lenders, strong credit quality and deep liquidity. But why might an investor only look at the Big Four?

First, the position of subordinated debt in the capital structure as well as its unsecured nature means that credit risk matters significantly. The Big Four banks are well-capitalised and, in the event of a major crisis, would be more likely to receive assistance from the government and regulators. By contrast, smaller banks may carry lower credit ratings and may be less likely to receive funding from the government in a crisis.

Second, debt issued by the Big Four banks is large, frequent, well-traded and well-known to investors and advisers alike. In other words, familiarity is a major asset during uncertainty.

Finally, the spread between a 5-years-to-call Big Four Tier 2 bond and a 5-years-to-call Big Four senior bond is generally between 50 to 100 bps. A smaller bank’s Tier 2/senior bond spread is generally tighter, meaning that investors may not receive enough compensation for the additional risk they are taking on.

Earn more from the Big Four

As the hybrid market phases out, a rare window is opening. Subordinated debt from Australia's Big Four banks offers income investors access to opportunities that were once reserved for the big players. For those seeking to maintain quality bank income with greater stability, Tier 2 subordinated bonds represent a compelling substitute for bank hybrids.

To learn more about BSUB and its performance through the cycle, click here.