By: William Pirraglia
Tier 2 bonds are components of Tier 2 capital, primarily for banks. These are debt instruments like loans, more than equity items like stocks. As with all bonds and other debt securities, they do not confer ownership or voting rights, but they provide interest income to bondholders or owners. “Guaranteed” is not an appropriate word to combine with investments, but Tier 2 bonds “specify” income as an interest rate. Tier 2 bonds are generally subordinated debt, behind Tier 1 debt such as commercial loans.
Upper Tier 2 Capital
Tier 2 bonds are part of Tier 2 capital. In the context of banking institutions, for a mutual bank, Tier 1 capital is made up of deposits, and in the world of commercial banks, it is the money from the sale of shares. Tier 2 capital, from a bank’s perspective, is often divided into upper and lower Tier 2 capital. The key characteristics of higher Tier 2 capital are that it is often senior to Tier 1 capital because bond coupons are carry forward and cumulative over otherwise senior preferred and common stock.
Lower Tier 2 Capital
Lower Tier 2 capital, limited to a maximum of 25% of a bank’s total capital, is subordinate to Tier 1 and Upper Tier 2 capital. These bonds are cheaper for banks to issue and, since January 2013, under the Basel 3 rules, they are defined more strictly. Tier 2 bonds, unlike bank deposits or shares, are subordinated, in a secondary position, to commitments to depositors and shareholders.
Tier 2 bonds, depositors and general creditors
In addition to the stated rates of return, Tier 2 bonds are subordinated to depositors’ rights to interest payments, creditors’ rights to repayment, and other subordinated debt of a financial institution. Your investment and earnings are not insured by the Federal Deposit Insurance Corp. or anyone else, unlike your personal deposits up to $250,000. Because depositors and creditors have first claim to money and income, Tier 2 bonds carry higher risk than many competing bond investment options.
Perceptions of Tier 2 obligations
Although Tier 2 bonds generally carry higher interest rates than other bank investments, they do not receive high marks for Investors’ Choices due to their significantly higher risks. Banks are subject to legislative restrictions on the issuance of Tier 2 bonds, which cannot exceed 100% of Tier 1 capital balances or 25% of total capitalization. Although investors like the higher rates offered by Tier 2 bonds, the perceived higher risk keeps many investors away.