Deemed residual maturity

Some bank bonds have no maturity date at all. Additional Tier 1 (AT1) bonds are perpetual: the bank may call them back on a call date, but it does not have to, and they can absorb losses before equity in some situations.

A fund still has to value them and state the portfolio's duration. So SEBI prescribed a deemed residual maturity: a maturity the fund must pretend the bond has for valuation and Macaulay duration.

To avoid a sudden price shock when the rule was introduced, the deemed maturity for AT1 bonds was stretched in steps, from 10 years to 100 years.

The glide path (Chapter 7):

Macaulay duration of these bonds is calculated on the deemed residual maturity in the table.

If the call is not exercised on the call date, valuation and Macaulay duration use 100 years from issue for AT1 and contractual maturity for AT2. If non-exercise reflects the issuer's financial stress or bad news, that must be reflected in the valuation.

Valuation basis: SEBI has decided that AT1 bonds are valued by mutual funds on a Yield to Call basis.

Related limits on these instruments:

• No mutual fund may own more than 10% of such bonds issued by a single issuer.
• A scheme may not invest more than 10% of its assets in such instruments, and not more than 5% of its assets in such instruments of a single issuer (the workbook prints "single investor"; the context is the issuer).
• Holdings already above the limits are grandfathered, with no further investment.
• Close-ended debt schemes can invest only in instruments maturing before the scheme ends, so they cannot hold perpetual bonds deemed to mature 100 years after issue.

The bond and scheme below are illustrative; the rules are the workbook's.

A bank issued an AT1 bond on 15 July 2020, with its first call date on 15 July 2025.

Each step lengthened the deemed maturity, and with it the bond's Macaulay duration, so the rule was phased in rather than applied overnight.

Limits check for an open-ended debt scheme with net assets of Rs 2,000 crore:

Maximum in all such bonds       = 10% × 2,000 = Rs 200 crore
Maximum in one issuer's such bonds = 5% × 2,000 = Rs 100 crore

If the bank's total AT1 issue is Rs 1,500 crore, the whole mutual fund (all its schemes together) may own at most 10% × 1,500 = Rs 150 crore of it.

A 3-year close-ended FMP cannot hold this bond at all: it can only invest in instruments maturing before the scheme ends.

Chapter 7 (Net Asset Value, Total Expense Ratio and Pricing of Units) covers the valuation of perpetual bonds: the exposure limits, the deemed residual maturity table, the call-not-exercised rule and Yield to Call valuation. Expect a question on the deemed maturity of AT1 bonds from April 1, 2023 (100 years from issuance), on AT2 (contractual maturity), and on the 10% / 10% / 5% limits.

• 100 years is counted from the date of issuance, not from the valuation date.
• AT2 bonds use contractual maturity after March 31, 2022; only AT1 moved to 20, 30 and 100 years.
• Till March 31, 2022, AT2 was 10 years or contractual maturity, whichever is earlier.
• Three different 10% and 5% limits: 10% of one issuer's such bonds (fund level), 10% of scheme assets (all such bonds), 5% of scheme assets (one issuer).
• Valuation of AT1 is on Yield to Call, while Macaulay duration uses the deemed residual maturity.
• Close-ended debt schemes cannot hold perpetual bonds.