Tier 2 Bank Bonds: Balancing Risk and Rewards


Understanding Bank Debentures and Deposit Guarantee

A debenture issued by a bank, rather than a corporate could be an easy way to describe the next level of bank borrowings, having less risk than a Tier 1 Bond (or AT-1 bond) in case of a bank default. We have just looked at the AT-1 Bond in our last conversation.

In fact, in the event of a bank default even Fixed Deposits are now insured only to the extent of Rs. 5 lakhs per person, per bank. This was just Rs. 1 lakh till some months ago. Note that it does not help to make multiple smaller deposits in many branches as the insurance covers the entire bank and all deposits made by a person.

Deposit guarantee insurance was first offered in the United States of America in 1934 and India introduced the guarantee only in 1962. Still, India is the second country in the world to offer deposit guarantee on bank fixed deposits, even if it took 28 years and the collapse of the Laxmi Bank and Palai Central Bank to trigger this action.

Beyond the basic Rs. 5 lakhs of deposit guarantee there is no major difference in the risk of lending to a bank (which is the role played by making a fixed deposit, or buying a bank bond). The higher interest earned on these bonds (currently ranging from 6.5% to 11% depending on the pedigree and credit rating of the issuing institution) is more than fair compensation for the marginally higher risk that these bonds bear compared to fixed deposits.

Additional sweeteners are the possibility of earning more than just interest. Bond prices are quick to react to changes in interest rates in the economy, as well as to liquidity and Tier 2 bank bonds have appreciated substantially to these stimuli during recent months. Bonds are somewhat liquid, though not as easy to encash as breaking up a fixed deposit.

Exploring Tier 2 Bonds and Risk Levels

The capital of banks is composed of three levels. Tier 1 is share capital and reserves at the top of the risk ladder, followed by AT-1 bonds. Tier 2 can be a maximum of 100 percent of tier 1 and is composed of provisions, revaluation reserves (that is increase in the value of assets owned by a bank), and tier 2 bonds. Tier 2 bonds can be written off or converted into common equity upon declaration of Point of Non-Viability (PONV) by the Reserve Bank of India (RBI). This has happened in the case of Lakshmi Villas Bank where Tier 2 Bonds were written off.

In their structure, Tier two bonds are a form of “subordinated debt” (to fixed deposits) because they do not have the first claim on assets in the event of bank liquidation. Tier 2 bonds are a form of long-term investment and bank liability.

Tier two bonds have a minimum five-year maturity and they are subject to regular amortization, which is an essential feature of debentures. Amortization is to set aside reserves for the redemption of the bond during its lifetime.

Tier 2 capital, from a bank perspective, is often divided into upper and lower tier 2 capital. The primary features of upper tier 2 capital are that it is senior to tier 1 capital, and carries less risk.

Lower tier 2 capital, restricted to 25 percent maximums of a bank’s total capital, is subordinate to tier 1 and upper tier 2 capital, meaning that it is at the lowest rung of risk among tier 1 and tier 2 capital of a bank. The relatively low-risk investor in bank debt would find these bonds worth a good long look.

Previous articleDemystifying the Yield Curve: Market Insights
Next articleDeep Discount Bonds vs. Zero Coupon Bonds Explained


Please enter your comment!
Please enter your name here