Tier 2 Bonds

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.

News Source: The Hindu