Tier 2 Bonds

Tier 2 bonds are subordinated debt instruments issued by banks to meet their Tier 2 regulatory capital requirements under the Basel III framework. They are less risky than AT1 bonds (which are perpetual and can be written off), because Tier 2 bonds have a fixed maturity, and their write-down or conversion to equity only happens at the point of non-viability (when the bank is on the brink of failure), not at a specific capital trigger.

What Are Tier 2 Bonds?

Under Basel III, bank capital has three layers:

1. **Common Equity Tier 1 (CET1)**: core equity (shares, retained earnings) — the safest and most loss-absorbing
2. **Additional Tier 1 (AT1)**: perpetual bonds that can be written down at a specific capital trigger
3. **Tier 2**: subordinated bonds with a fixed maturity of at least 5 years

Tier 2 instruments are more senior than AT1 bonds in the capital structure. In a liquidation scenario, Tier 2 bondholders are paid before AT1 and equity holders, but after depositors and senior unsecured creditors.

Key Features

– **Fixed maturity**: minimum 5 years; typically 10 years
– **Subordinated**: junior to depositors and senior creditors; senior to AT1 and equity
– **Point of Non-Viability (PONV) clause**: RBI can write down or convert the bonds to equity if the bank reaches the point of non-viability
– **No coupon suspension**: coupons are not discretionary (unlike AT1)
– **Higher yield than senior bonds**: compensates for subordinated status and PONV risk

Tier 2 vs AT1 Bonds

| Feature | Tier 2 Bond | AT1 Bond |
|———|————|———-|
| Maturity | Fixed (5+ years) | Perpetual |
| Write-down trigger | Point of non-viability | CET1 falls below 5.5% |
| Coupon | Mandatory (no discretion) | Bank can skip if needed |
| Risk | Moderate | High |
| Yield | Moderate (8-9%) | High (9-10%+) |

Practical Example

Axis Bank issues 10-year Tier 2 bonds at 8.4%. A mutual fund buys Rs 100 crore. The fund earns Rs 8.4 crore per year in interest over 10 years. At maturity, it receives Rs 100 crore back. The risk: if Axis Bank reaches a point of non-viability before maturity (which is an extreme scenario), RBI could write down these bonds. In practice, Tier 2 bonds from large Indian banks are considered very safe.

Key Takeaways

– Tier 2 bonds are subordinated, fixed-maturity bonds issued by banks as regulatory capital
– They are safer than AT1 bonds but more risky than senior bonds
– Write-down only occurs at the extreme point of non-viability, not at a specific capital trigger
– Coupons are mandatory, unlike AT1 bonds where coupon payment is at the bank’s discretion
– Large bank Tier 2 bonds are held by mutual funds, pension funds, and insurance companies