The recent by-elections should serve as a warning to investors reliant on franking credits for income. Significant swings to Labor while the Liberals stand by corporate tax cuts, increase the chance of a Labor victory and, with it, Labor’s stated policy of removing franking credit refunds to investors who do not pay tax.

Shares and hybrids would then become relatively less attractive to investors.

The shares would lose some of their shine, but I’d expect investors to largely keep holding them, with bank dividends around 5-6 per cent per annum, still deemed ‘attractive enough’.

It’s worth reinforcing that bank share prices and capital aren’t guaranteed. CBA’s 6 per cent dividend looks appealing, but had you invested a year ago, its share price is down circa 12 per cent. So, even if you are able to claim franking credits with a combined income of roughly 8 per cent, you would still be facing an overall loss of 4 per cent over a one year term.

Too many investors discount movements in the share price for prized dividend income, even though dividends can be cut or not paid at all. Whether you are investing for income or growth, bank shares are a gamble. Subordinated bonds, issued by many Australian financial institutions, are far better for income investors. I’ll circle back to them in a moment.

Complex hybrids have been long term favourites of income seeking investors. Loss of franking credits especially in this low interest rate environment, takes away any premium over lower risk subordinated bonds, which then become a far superior investment.

For example, the ANZPF has first call in 2023, so roughly a five year term. It has a yield including franking of 5.71%pa, but take away the franking and the annual return declines to about 4%pa.

All the major bank securities trade in a tight range, so a Westpac subordinated bond of similar term pays 4.1%pa, but is only available in $500,000 parcels. While Bank of Queensland, also has a subordinated bond over a similar length with a yield to expected maturity of 4% with lower minimums to invest.

How do subordinated bonds and hybrids differ?

Risk increases at each stage, as you move down the capital structure. Starting with deposits, then senior unsecured bonds, subordinated bonds to hybrids and finally to the highest risk investment, shares.

Compressed interest rates make differentials between the investments smaller in the capital structure stack than historical averages.

In any investment there are risks.Both the subordinated bond and the hybrid have call dates, typically after five years for the bond, but a range for the hybrid that could be up to eight years. However, the bond has a final maturity date, usually at 10 years, while the hybrid has conditional conversion dates subject to APRA approval.

Failure to meet the conversion conditions means the hybrid becomes perpetual and investors must decide to sell at market rates to recoup capital.

The bond is issued at $100 and investors expect $100 to be returned at maturity. While bond prices move over the life of the bond, the return of face value at maturity helps preserve capital.

Income is specified for both investments. However income on the bond must be paid, otherwise it is a ‘default event’. The hybrid is designed to be loss absorbing and protective of the bank’s survival, so income can be forgone and never has to be paid.

There is a dividend stopper clause, somewhat protecting hybrid investors, but the risk of loss of income remains.

Income on the hybrid can also be scaled down if minimum capital levels are breached, with a floor of 8 per cent. Should capital fall below 5.125 per cent, the hybrid automatically converts to highest risk shares. No such clause exists for the bond.

In the worst case scenario, APRA can deem the institution ‘non viable’ where both investments convert to shares.

So, on a risk versus reward assessment, the hybrid return is insufficient for investors if they cannot claim franking credits.

My suggestion is to sell and consider other options, one being direct investment in subordinated bank bonds.

A version of this note was published in The Australian on 4 August 2018


eric wells

ALL self funded, or part self funded retirees should NEVER, NEVER, VOTE Labor, or we will be knifed. This is outright thievery. Eric Wells

Edward Ensel

eric is right labor will be high taxing govt if elected

william frederick roberts

Congrats Elizabeth, first time I have heard this stuff explained esp the automatic conversion on hybrids when the ordure really collides with the atmospheric oscillator. Fixed income investors have taken a kicking for many years but maybe the tariff wars will change that. Divvy vampires like me are watching the polls nervously, but hopefully LNP stealing policies from Labor will see them re-elected next year and we can all relax again . . .

paul kibble

IF this happens I will simply wind up the smsf as it is in pension mode. Use the franking credits to offset any tax payable, save money by not paying for admin and compliance and get the government's nose out of my business.


If labor is going to tax SMSF pension income from shares, then they have to be consistent and tax ALL pension income received; from bonds, bank interest, property income, etc, etc.

peter calo

Typical response from selfish people like Eric and Edward, looking out for number one and ignoring the rest of the country. Labor's policy is good policy for the country. Why is it that foreign tax offsets on dividends are NOT refundable but local dividends for companies like Telstra are refundable? The current situation is inconsistent and illogical. Tax offsets were always designed to reduce your tax to zero, but not to be refundable. Why are franking credits different? By all means franking credits should reduce tax to zero, but they should not be refunded. When you think about the country and not just your own hip pocket you realise the country cannot afford it.

William Allan Cross

The problem is small investors have limited ability to access Bonds other than through ETF's. My understanding is that is less than ideal because there is no end date like when holding individual bonds.

Elizabeth Moran

That's true William, in an ETF you have no maturity date, whereas direct investors have that comfort. Also, in some cases income is high but the yield to maturity is much lower and not attractive, so investors really need to dig a little to get the full picture.

sachin saraf

What Politicians say before elections and what they do when in power can have a std deviation of 50% ;-) .

Robin Memory

Peter C, when you have set your retirement strategy for 10 years in advance and planned your income to come from shares in your retirement, and then at the thought bubble of a politician you get an income haircut of 20% with no phase in period and no opportunity to re-adjust it seems a bit unfair to me. But if you've geared a few houses like our pollies, that's cool, no haircut for you. I can't earn the money again. I have what I have. I like many will re-adjust my affairs and probably start to invest overseas for growth. Labor will not have to pay me franking credits, but neither will they book the huge rip off that they plan to. I am also greatly troubled at the pointed nature of the tax grab. Tell me why a CEO earning $400k a year will be untouched by the changes? Tell me why the country can still afford negative gearing? I'll answer that one, it can't, but it won't get canned overnight because that would be election losing. Do you think it will be good for Australia to have blue chip shares under supported from within the country? This is not good for the country, but it is good for the industry funds that have Bill by the short and curlies. This is a soft target that is popular with the masses. I hope when you retire you may be a little more sympathetic in your views perhaps. For the record I have been a Labor voter for many years and I have written to Shorten twice on this, but he can't find the time to respond as I am part of a minority group. Lost me.

Peter A

Unfortunately, refundable franking credits ended up as too much of a good thing. Given the sheer number of investors who ended up taking advantage of the refunds, it was never going to be sustainable and it was probably inevitable that it was going to get scaled back by a future government one way or another.

Trevor Ridgway

To Peter C , Peter A and Robin , Edward , Eric and all ! Some good points in each of your comments but .......... as I see it .....Australians were encouraged to "buy back the farm" from foreign investors and support Australian companies by offering investors Franking Credits. (The company can determine the % franked ) It was also to encourage Australians to invest in their own future retirement ! Either way, the company paid the tax due IF it made a profit. It was then at liberty to pay dividends to it's shareholders.These were tax paid dividends, tax free in the hands of the shareholder. The Government already had collected it's tax ! To deny tax free dividend payments to the shareholders is outright theft. That is what Labor is promising to do with Franking Credits. Theft from the people who are legally entitled to the refund of the tax that their company has paid on their behalf to the Government which is then obliged to on-pay that benefit to the shareholder as per the initial agreement. The claim that it is being paid out of Government funds is spurious and dishonest. It never belonged to them in the first place.