What Are Tier 2 Bonds?

Tier two is one of the three levels that make up the capital structure found in banks. Tier one capital contains a bank's principal capital and consists mostly of common stock and retained earnings. Tier two capital is limited to 100 percent of tier one and is considered a secondary level of bank capital consisting mostly of revaluation reserves, which contain amounts related to increases in the value of company assets; general loss provisions, or amounts that will absorb unidentified losses; and subordinated debt, such as bonds. Tier two bonds are a form of subordinated debt because they do not have first claim on assets in the event of a bank liquidation.

Tier two bonds have a minimum five-year maturity and they are subject to regular amortization. These bonds are sometimes issued as a part of asset-backed securities, or securities that are backed by an underlying pool of assets, and collateralized mortgage obligations, a concept where mortgages are transformed into bonds in order to sell them to investors.

Attorneys Mark Van Der Weide and Satish M. Kini write in the Boston College Law Review about the ability of subordinated debt, such as tier two bonds, to curtail bank risk taking due to the presence of long term debt-holders who tend to keep a watchful eye on their investments. The market response of these long-term debt holders to actions taken by the bank can tip off regulators on potential problems. Issuing this type of debt also increases bank disclosure of financial information, resulting in greater transparency of the bank's activities.

Since they are a form of subordinated debt, tier two bonds are considered a riskier form of investment that must carry a higher rate of return. Investors run the risk of not collecting on their investment if the bank becomes insolvent because they have a secondary claim on assets. The amount of tier two bonds issued by a bank can be used as a measure to establish the amount of deposit insurance premium charged to the bank by the Federal Deposit Insurance Corp., or FDIC.

Tier two bonds are not considered an attractive form of debt for banks due to the higher interest rates the issuer must pay. Investors earn a higher rate of return due to the higher risk involved in the investment. Other risk premiums and covenants may be negotiated by debt holders as additional investment protection.