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What Are Tier II Bonds? Meaning, Benefits & Risks

Imagine a bank as a business that needs money to lend to customers and grow. Just like you might have savings and a credit card, banks maintain different layers of capital to ensure financial stability" – more precise. One important layer is called Tier 2 capital, which banks build by issuing special, Tier 2 bonds.

These bonds are a kind of loan the bank takes from investors, but with a twist—they are riskier than regular loans because they get paid back after other debts if the bank runs into trouble. However, they are safer than the bank’s own shares (equity). Indian banks often use these Tier 2 bonds to raise extra money without selling more shares, which means existing owners don’t lose their share of the bank. This helps banks meet regulatory rules, manage growth, and maintain strong finances without diluting ownership.

What are Tier 2 Bonds?

Tier 2 bonds are integral to a banking capital’s second layer. Categorised as subordinated debt instruments, they provide repayment after higher-ranking debt avenues in case of bankruptcy or liquidation.

Since these are subordinated bonds, they usually offer higher interest rates than other bond types. At the same time, they are riskier for investors because their repayment depends on fulfilling higher-ranking debt holders’ obligations. The bank must follow legislative restrictions when issuing these bonds to protect investors and creditors. It prevents the reliance on subordinated debt, which weakens a bank’s position in finance and stability.

Purpose of Issuing Tier 2 Bonds

Tier 2 bonds are specific debt instruments all banks issue to raise operational capital. They fall under Tier II capital, ranking below Tier I capital in repayment priority. Issuing them primarily aims to strengthen a bank’s capital adequacy ratio, which measures its financial stability and health. The capital adequacy ratio is calculated by dividing total capital by risk-weighted assets, its risk-weighted assets.

With Tier 2 bonds, a bank ensures it has sufficient capital to lend money and absorb losses. They provide additional capital to meet a bank’s regulatory requirements and maintain sound finances. Investors find them attractive investment options due to their higher coupon rates. However, they have associated risks in terms of liquidity in the secondary capital market. 

Benefits of the Tier 2 Bonds

Tier 2 bonds are beneficial for both investors and banks. Let’s take a look:

Benefits for Banks

  • Flexibility: A bank may raise capital through Tier 2 bonds.
  • Lower Capital Cost: Tier 2 bonds avoid diluting a bank's shares while mobilising capital. Therefore, they are an inexpensive source of funds compared to new equity.
  • Funding Diversification: Incorporating these bonds into the funding pool assists all banks in diversifying their funding sources. By doing so, they minimise their dependence on a single funding source, making them more financially stable.

Benefits for Investors 

  • Diversify Investment Portfolio: Tier II bonds are efficient investment instruments that diversify portfolios.  They provide an alternative to equity for generating steady fixed income
  • Attractive Investment Options: Tier 2 bonds have higher coupon rates than other fixed-income instruments, making them attractive investment options for those seeking high returns.

Risks Associated with Tier 2 Bonds

Imagine you bought a Tier 2 bond from a bank because it offers a higher interest rate than regular savings. Sounds good, right? But what if the bank faces financial trouble?

Since Tier 2 bonds are a kind of subordinated debt, It may be difficult to sell the bond before maturity, especially in a low-liquidity market. or, worse, lose your invested money if the bank goes bankrupt (capital risk). Plus, you need to trust the bank’s creditworthiness because if it’s weak, the risk of default is higher (credit risk). 

Here are the key risks associated with Tier 2 bonds explained simply:

  • Liquidity Risk: These bonds are not frequently traded, so selling them before maturity can be difficult, and you might have to sell at a loss.
  • Credit Risk: The bank issuing the bond might face financial problems, so checking the bank’s credit rating before investing is crucial.
  • Capital Risk: If the bank goes into liquidation or needs to cover losses, Tier 2 bondholders may lose part or all of their invested capital since these bonds are subordinate to other debts.
  • Subordination Risk: In case of bankruptcy, Tier 2 bonds get paid only after senior debts are settled, increasing the chance of losses.
  • Redemption Risk: The bank may face difficulties repaying the bond at maturity, especially if market conditions are unfavourable.
  • Regulatory and Event Risks: Certain regulatory events or financial distress can cause bonds to be written off, causing investors to lose their entire investment.

So, while Tier 2 bonds offer attractive returns, they come with significant risks that investors and banks must consider carefully.

Key Considerations for Investors Investing in Tier 2 Bonds

Those considering investment in Tier II bonds must check these points before investing:

  • Understand the subordination risks and the risk of write-downs.
  • Check the issuing bank’s credit rating and financial stability before investing.
  • Diversify the investment portfolio instead of solely relying on Tier II bonds.
  • Use a reliable platform like Bondbazaar to assess a bond’s suitability for risk tolerance.

Future of Tier 2 Bonds in India

Imagine you want to invest in bonds that offer higher returns than fixed deposits but come with some extra risk. That’s where Tier II bonds issued by Indian banks come in. These bonds help banks raise capital to grow while offering investors attractive fixed interest rates, often between 8-14%*.

However, since they are subordinated debt, they carry higher risk, meaning if the bank faces trouble, these bondholders get paid after other creditors.

The future of Tier II bonds in India looks promising as banks continue to issue them to meet regulatory capital requirements and fuel growth. The Indian bond market is expected to remain strong in 2025, supported by the RBI’s potential rate cuts and steady demand from institutional and retail investors. Tier 2 bonds could be a valuable part of your portfolio.

Bondbazaar makes investing in these bonds easier and more transparent by offering a wide selection of bonds, real-time trading, zero charges, and the ability to buy or sell bonds instantly, all regulated by SEBI. This combination of convenience and expert backing helps retail investors effectively balance risk and returns.