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Banks use Tier II bonds to raise money and meet the regulatory norms according to the Basel III regulations. These bonds are essentially subordinate debts and are not the first to be prioritised for payment. However, the Tier II bonds are still senior to Tier I bonds, so they are prioritised more during the liquidation process. Banks can issue Tier II bonds even in foreign currency. However, it can be done only after RBI has approved the request, and it is performed only on a case-by-case basis.
Benefits of the Tier II Bonds
Both investors and banks can benefit from the Tier II bonds. The following are the benefits received by the investors:
Investment Portfolio Diversification
The Tier II bonds are an excellent way of diversifying the portfolio. Investors can diversify their portfolios by including debt instruments like Tier II bonds, rather than relying solely on equity for capital appreciation.
Attractive Investment Option
Tier II bonds come with a higher coupon rate than any other fixed-income instrument. This makes them an attractive investment option for those seeking high returns.
The following are the benefits that banks receive by issuing Tier II bonds.
Lower Cost of Capital
Tier II bonds are a cost-effective capital source for banks because they do not need to issue new equity to raise the capital. Issuing fresh equity dilutes the holdings of the existing shareholders.
Flexibility
Tier II bonds have great flexibility for banks since they can be issued and redeemed whenever required. The bank is able to respond fast to fluctuations in capital requirements through these Tier II bonds.
Diversification of Funding Sources
The Tier II bonds help diversify the bank’s funding mix and decrease its dependence on only a single source of funding. This will lead to a more stable funding structure.
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Risks of Investing in the Tier II Bonds
While investing in Tier II bonds has several benefits, it also has a few risks. The following are some of the risks that investors may face:
Liquidity Risk
The Tier II bond is not traded a lot in the secondary market. So, one might face difficulty in selling these bonds at a later date.
Credit Risk
Tier II bonds provide a high coupon rate, but people still need to check the credit ratings of the bank before investing.
Capital Risk
The Tier II bonds could lose capital if the bank needs to cover its losses and goes into liquidation. If the bank faces financial difficulties, both the bonds and their investors may be adversely affected. So, it’s necessary to choose the right issuer to invest in these bonds.
Wrapping Up!
Tier II bonds can be a lucrative investment, but they have to be made with the right bank. Generally, the public sector banks tend to get their funding from Tier I bonds. On the other hand, it’s the private sector banks that lean more towards Tier II bonds. As such, focus on comparing and skimming through the private banks to invest in the right bond.
FAQs About What are Tier II Bonds?
1. What are the characteristics of the Tier II bonds?
Tier II bonds are like a second layer to the bank’s capital, and they have qualities such as subordinate debt, hybrid instruments, and revaluation reserves. It’s a little less secure than the Tier I bond, and they can also be challenging to liquidate.
2. What is the difference between the Tier I and the Tier II bonds?
The Tier I bond is a bank’s primary source of funding, and it consists of retained earnings and shareholders’ equity. In comparison, the Tier II bond is a secondary source of funding and consists of general loan-loss reserves, revaluation reserves, etc.
3. What kind of rating is the best for Tier II bonds?
The best credit rating for bonds is AAA. This means that the bank has an extremely strong capacity to meet financial obligations. However, you can also go for banks that have an AA rating since even they have a strong capacity.
