Defensive allocations in flux as hybrids exit and volatility rises

For years, advisers relied on a simple formula for defensive allocations. They blended high grade credit, term deposits and bank hybrids. As a result, many portfolios delivered income of cash plus 3 to 4 per cent with manageable volatility.

However, that formula is now under pressure. Equity markets have turned volatile again. At the same time, regulators and issuers have removed bank hybrids from the market. Consequently, advisers must rethink how they build the defensive sleeve.

The hybrid cliff

The decline of Additional Tier 1 capital instruments is structural. It is not a short term market cycle. As banks refinance and adjust to new capital rules, the supply of listed hybrids continues to shrink.

According to Alex Veroude, Global Head of Fixed Income at Janus Henderson, the impact is already clear. “With the decline of Additional Tier 1 capital instruments, investors are increasingly seeking reliable listed alternatives,” he says.

Previously, hybrids played a central role in income portfolios. They offered a listed security with an attractive running yield. Moreover, many clients viewed them as a step up from term deposits. Now that segment has narrowed sharply, advisers must find alternatives that can deliver both income and liquidity.

Meanwhile, equity volatility tests client resolve

Equity markets no longer offer a smooth ride. Inflation uncertainty, geopolitical risk and uneven growth have increased daily swings. As a result, clients feel more sensitive to drawdowns.

At the same time, traditional bonds have not provided perfect shelter. The rapid rate hiking cycle exposed duration risk in many portfolios. Consequently, some defensive funds delivered capital losses when clients expected stability.

Therefore, advisers face a twin challenge. They must reduce equity risk. Yet they still need to generate reliable income in a higher rate world.

A new listed income solution

Against this backdrop, Kapstream Capital has lodged a product disclosure statement for the Kapstream Investment Trust, or KIT. The trust aims to provide access to investment grade Australian and global fixed income securities as well as Australian private asset backed securities. It is expected to list on the ASX in March.

Importantly, KIT is targeting a capital raise of between $200 million and $300 million. In addition, it has already secured $145 million through cornerstone commitments.

Initially, the portfolio will allocate around 50 per cent to the Kapstream Absolute Return Income strategies and 50 per cent to the Kapstream Private Investment Fund. The trust is targeting monthly distributions and a return of the RBA Cash Rate plus 3.50 per cent per annum, pre-tax and net of fees and costs.

Blending public and private credit

Private credit has attracted strong flows in recent years. However, many vehicles operate in unlisted structures with limited redemption windows. As allocations grow, liquidity management becomes more complex.

By contrast, KIT uses a listed investment trust structure with specific liquidity features. It includes limited quarterly redemption buyback windows and the potential for on market buybacks. Furthermore, the allocation to relatively liquid investment grade fixed income securities helps support these mechanisms.

As Daniel Siluk, Managing Director and Lead Portfolio Manager at Kapstream, explains, clients want to combine public and private credit in a dynamic way. Therefore, the structure seeks to enhance portfolio liquidity while still targeting compelling returns.

Diversification at the loan level

The private allocation does not focus on corporate or real estate private debt. Instead, it targets asset backed securities diversified across mortgage, auto, personal and medical practice receivables. Consequently, investors gain exposure to thousands of underlying loans rather than a small number of bilateral deals.

Moreover, the strategy includes exposure to pre public securitisation markets, often referred to as warehouses. According to Dylan Bourke, these structures can offer high-quality, short duration assets with what is considered to be an attractive risk-adjusted return profile. Typically, they include first loss capital from originators, subordination and excess spread features.

As a result, the income stream rests on diversified receivables and embedded credit enhancements. For advisers concerned about concentration risk, that structure may prove attractive.

Structure now matters as much as yield

Of course, risks remain. Credit risk, interest rate risk and liquidity risk still apply. In addition, units may trade at a discount to net asset value on the ASX. Advisers must assess these factors carefully.

Nevertheless, the broader shift is undeniable. Hybrids are disappearing. Equity volatility has returned. Private credit continues to expand, yet liquidity cannot become an afterthought.

KIT, as part of the group of LIT 2.0 structures (usually IPO’s post 2024), addresses liquidity directly through an ASX listing, as well as through a potential 5% quarterly off market buy back at NAV. This is unlike ASX listed notes and LIT 1.0 vehicles which usually have no formal liquidity commitment aside from secondary market trading. Private unlisted debt funds generally have low liquidity, usually relying on monthly or quarterly redemptions where lock ups may occur.

Therefore, advisers should re-examine the defensive bucket with fresh eyes. They should ask how income is generated. They should test how the strategy behaves in a credit event. Finally, they should assess whether the vehicle provides sufficient liquidity for client needs.

In the next phase of the cycle, defensive allocations will look different. Listed vehicles that blend public and private credit may take a larger role. In a market adjusting to structural change, resilience and liquidity now sit at the centre of portfolio construction.

Laurence Parker-Brown

Laurence Parker-Brown is head of content at The Inside Network and managing editor of The Inside Adviser and Investor Strategy News.