Introduction

Tier-2 bonds are subordinated debt instruments that banks issue to strengthen their Tier-2 capital, which is an essential component of regulatory capital under Basel III norms. These bonds are riskier than senior debt instruments but rank higher than equity in the capital structure.

In India, banks have increasingly turned to Tier-2 bonds to manage capital adequacy, meet credit demand, and bridge the gap between deposit growth and credit expansion. As credit demand continues to rise, banks are using this instrument as a cost-effective way to raise capital without diluting equity.

This article explores the recent trends in Tier-2 bond issuances, factors driving the surge, regulatory guidelines, and associated risks for investors in India.

Recent Trends in Tier-2 Bond Issuance

In the fiscal year 2022-23 (FY23), Indian banks witnessed a sharp increase in Tier-2 bond issuances, reflecting their efforts to strengthen capital buffers while catering to rising credit demand.

Total Issuance: Banks collectively raised over ₹59,600 crore through Tier-2 bonds in FY23, marking a 3.5x increase compared to the previous year.

Major Issuers:

• HDFC Bank: Raised ₹20,000 crore through Tier-2 bonds.
• State Bank of India (SBI): Issued ₹13,718 crore in Tier-2 bonds.
• Axis Bank: Raised ₹12,000 crore via Tier-2 bonds.

This surge in issuance highlights how banks are leveraging Tier-2 bonds to manage their capital needs while balancing liquidity constraints.

Factors Driving Increased Tier-2 Bond Issuance

Several key factors have contributed to the surge in Tier-2 bond issuances by Indian banks:

1. Robust Credit Growth

• Banks experienced a significant uptick in loan demand, requiring additional capital to support lending activities.
• As economic activity recovered post-pandemic, corporate and retail credit demand surged, prompting banks to raise capital.

2. Deposit-Credit Growth Gap

• Banks faced a shortfall in deposits relative to credit expansion, creating the need for alternative funding sources.
• As of FY23, the incremental credit expansion stood at ₹12.7 trillion, while deposit growth trailed at ₹8.9 trillion, widening the funding gap.

3. Regulatory Compliance & Basel III Requirements

• RBI requires banks to maintain adequate Tier-2 capital levels to ensure financial stability.
• Raising capital through Tier-2 bonds helps banks comply with capital adequacy norms without issuing fresh equity.

4. Cost-Effective Capital Raising

• Tier-2 bonds allow banks to raise long-term capital at a lower cost compared to equity issuance.
• Helps banks avoid dilution of shareholder value while meeting capital requirements.

Regulatory Framework Governing Tier-2 Bonds

The Reserve Bank of India (RBI) has established stringent guidelines for the issuance of Tier-2 bonds:

Inclusion in Tier-2 Capital:

• Subordinated debt instruments qualify as Tier-2 capital under Basel III norms.
• However, Tier-2 capital should not exceed 100% of Tier-1 capital.

Point of Non-Viability (PONV) Clause:

• RBI has the authority to trigger the permanent write-off or conversion of Tier-2 bonds into equity in case a bank reaches the point of non-viability.
• This mechanism enhances financial stability but increases investor risk.

Minimum Maturity & Call Options:

• Tier-2 bonds must have a minimum tenure of 10 years, with a call option available after 5 years.
• Early redemption is allowed only with RBI’s approval.

Interest Servicing Conditions:

• Interest payments are not guaranteed and can be skipped if the bank's capital levels fall below the regulatory threshold.

Risks Associated with Tier-2 Bonds

Although Tier-2 bonds are widely used by banks to strengthen their capital, investors must carefully consider the associated risks before investing:

1. Risk of Write-Down or Conversion

• Under the PONV clause, RBI has the power to permanently write down or convert Tier-2 bonds into equity if the issuing bank becomes financially unstable.
• This was witnessed in Lakshmi Vilas Bank’s case (2020), where Tier-2 bondholders faced a complete write-down before the bank’s merger with DBS Bank.

2. Subordination Risk

• Tier-2 bondholders rank below senior debt holders in the capital hierarchy.
• In case of liquidation, senior bondholders and depositors are paid first, increasing risk for Tier-2 bond investors.

3. Market Liquidity & Interest Rate Sensitivity

• Unlike government bonds or blue-chip corporate bonds, Tier-2 bonds are not highly liquid, making it difficult for investors to exit early.
• Their prices are sensitive to interest rate movements, meaning rising interest rates could lead to a decline in market value.

4. Credit Risk & Bank-Specific Factors

• The creditworthiness of the issuing bank determines the risk level of Tier-2 bonds.
• Investors should assess credit ratings and financial strength before investing in these instruments.

Should Retail Investors Consider Tier-2 Bonds?

While institutional investors, mutual funds, and pension funds frequently invest in Tier-2 bonds, retail investors must exercise caution. These bonds offer attractive yields, but they also come with higher risk compared to fixed deposits or government bonds.

Key Considerations for Retail Investors:

• Understand the risks of write-downs and subordination.
• Check the issuing bank’s financial stability and credit rating before investing.
• Diversify investments rather than relying solely on Tier-2 bonds.
• Consult a financial advisor to assess suitability based on risk tolerance.

Alternative Investment Options:

• Government Bonds (G-Secs): Safer but lower yield.
• Corporate Bonds: Slightly higher risk but less regulatory uncertainty.
• Bank Fixed Deposits (FDs): Low risk but offer lower returns.

Future Outlook for Tier-2 Bonds in India

With continued economic expansion, rising credit demand, and regulatory changes, Tier-2 bonds are expected to remain a key instrument for banks to raise capital.

• More frequent issuances by private and public sector banks are likely.
• Potential regulatory refinements to enhance investor confidence in Tier-2 instruments.
• Increased institutional participation, particularly from mutual funds and pension funds.

However, as seen with the Lakshmi Vilas Bank incident, investors should carefully assess the financial health of the issuing bank before investing in these bonds.

Conclusion

Tier-2 bonds have become an important capital-raising tool for Indian banks, especially in times of rising credit demand and funding gaps. While these instruments offer attractive returns, they also carry higher risks, including write-down clauses and subordination in the capital hierarchy.

Investors, particularly retail participants, should weigh the risks against potential returns and ensure that their investment aligns with their financial goals and risk tolerance. With RBI’s stringent regulatory oversight and increasing market participation, Tier-2 bonds are set to remain a crucial part of India’s financial landscape.