Tier 2 Bonds

GS Paper III Indian Economy

Context:

IDFC First Bank said it had raised ₹1,500 crore of Tier2 bonds in the domestic bond market.

About Tier-2 Bonds:

Tier-2 bonds are a type of debt instrument banks issue to raise capital for their operations.
Tier-2 bonds form a part of the bank‘s Tier-2 capital and are subordinate to Tier-1 capital.
Banks are allowed to issue even foreign currency Tier-2 bonds on a case-by-case basis after taking the approval of the RBI.

Benefits of Tier-2 bonds:

Flexibility: Tier-2 bonds offer greater flexibility to banks in terms of raising capital as they can be issued and redeemed as and when required by the bank.
- This helps banks respond quickly to changes in their capital requirements.
Lower Cost of Capital: Tier-2 bonds are considered a cost-effective source of capital for a bank because banks do not have to issue new equity to raise capital, which can dilute the holdings of existing shareholders.
Diversification of Funding Sources: Tier-2 bonds provide banks with another source of funding, which helps to diversify their funding mix and reduce their dependence on a single source of funding.
- This, in turn, enhances the stability of their funding structure.
Attractive Investment Option: These bonds offer a higher coupon rate compared to other fixed-income instruments such as government bonds and fixed deposits.

Risks:

Capital Risk: Tier-2 bonds carry a risk of losing capital in case a bank goes into liquidation or needs to cover the losses.
Credit Risk: Although Tier-2 bonds offer a higher interest rate coupon, investors should check the banks‘ credit ratings before making investments.
Liquidity Risk: These types of bonds are not widely traded in the secondary market and investors may find it difficult to sell these bonds.

What Is Tier 2 Capital?

The term tier 2 capital refers to one of the components of a bank’s required reserves.
Tier 2 is designated as the second or supplementary layer of a bank’s capital and is composed of items such as revaluation reserves, hybrid instruments, and subordinated term debt.
It is considered less secure than Tier 1 capital because it’s more difficult to liquidate.

Additional Information:

About Bonds:

A bond is a fixed-income instrument that represents a loan made by an investor to a borrower (typically corporate or governmental).
Bonds are used by companies, municipalities, states, and sovereign governments to finance projects and operations.
Bond prices are inversely correlated with interest rates: when rates go up, bond prices fall and vice-versa.
Bonds have maturity dates at which point the principal amount must be paid back in full or risk default.
Bond details include the end date when the principal of the loan is due to be paid to the bond owner and usually include the terms for variable or fixed interest payments made by the borrower.

Additional-Tier- 1 Bonds:

AT-1 bonds are perpetual instruments as a result of which they have no maturity date.
The coupon rate on these bonds differs as per market conditions.
These debt instruments offer higher returns to investors but they also carry a higher risk.
Banks use these bonds to augment their core equity base and thus comply with Basel III norms.
These bonds were introduced by the Basel accord after the global financial crisis to protect depositors.