Municipal bonds : Financing our urban infrastructure since 1990’s

Municipal bonds or ‘Munis’ are a very popular type of fixed income securities in the US. These bonds are debt securities, issued by local governments, or municipalities in the US. They are likely to become more popular in India as time goes by. In the US, there may be about two million Muni issues outstanding at any point of time. Consequently, there could be issues pertaining to liquidity. That is, people who seek to sell such bonds may face issues in locating suitable buyers at a mutually acceptable price.

Municipalities are government entities like the central or federal government of a country and its state governments. Consequently, they cannot issue equity shares. Thus, bonds represent the only securities they can issue to fund their expenses. To augment taxes, tolls, and other sources of income, municipalities therefore regularly issue bonds. Unlike central governments, which can always print more money, municipalities cannot.

Also, holders of such bonds may get some tax relief on the incomes earned from such securities. In the US, governments operate on the principle of mutual reciprocity. Federal government securities are exempt from state income taxes, while state government securities are exempt from Federal income taxes

They can be classified into two types: 

• General Obligation (GO) Bonds which are used for general infrastructural needs and are repaid from the general government funds or taxes (like property taxes).
• Revenue Bonds which are used to finance specific projects. These are repaid through the revenues or taxes generated from these specific projects. 

Bangalore Municipal Corporation was the first urban local body to issue municipal bonds in India back in 1997 even though the first major breakthrough came in 1998 when Ahmedabad launched the first and only public issuance.

 Since then, other local bodies in the cities of Nashik, Nagpur, Ludhiana, and Madurai, have also accessed the capital markets through municipal bonds.

In 2017, the Pune Municipal Corporation (PMC) became the first local body in the country to issue these in nearly 15 years, raising Rs 200 crores for the Smart City project. 

 However, the market for municipal bonds remained bleak as close to ₹2,000cr ($268m) has been raised from 10 issues so far, quite modest in relation to India’s exploding urban investment needs. 

In India, there is a Pooled Finance Development Fund (PFDF) scheme under which a number of municipalities can pool together to raise funds through the joint issuance of bonds. They can be issued either publicly (in the open market) or through private placement. 

SEBI restructured the eligibility criteria for municipal bond issuance in 2015 to include two substantial changes:

• No negative net worth in the previous three fiscal years.
• No prior default in debt repayment in the previous year.
• No mention of municipal entities, their group companies, promoters or directors in RBI’s wilful defaulters list.

The same year, the Atal Mission for Rejuvenation of Urban Transformation (AMRUT) scheme was launched simultaneously where institutional incentives were offered to urban local bodies for participating in the bond issuance. For instance, for every ₹100cr ($13.4m) raised via bonds, the Government pays these bodies ₹13cr ($1.7m) which assists with meeting repayment targets. 

In February 2019, RBI enabled Foreign Portfolio Investment (FPI) into municipal bonds too. This was meant to ease the access of debt instruments in non-residents. Minimum subscription limit per investor was also reduced to ₹10L ($13,400) from ₹25L ($33,500) aligning them with corporate bond regulations. 

Municipal revenue forms less than 1% of India’s GDP, an abysmally low figure compared globally.

In India, the share of municipal bonds in the total debt market is nonetheless insignificant; only 1 per cent of urban bodies financial needs are met through municipal bonds as opposed to 10 per cent in the US. This is because the municipal bonds in the debt market have poor ratings. Out of the 94 cities evaluated by agencies such as CRISIL, only 55 received investment-grade ratings while the remaining 39 scored below-average. Moreover, city ratings are equivalent to bond ratings. What this means is that the credit rating is assigned based on the assets and liabilities of urban local bodies (ULBs), inclusive of revenue streams, resources available for capital investments, and other governance practices. 

To rectify this, the Ministry of Housing and Urban Development is compiling a database of audited annual accounts in line with international standards for local bodies for the first time. These efforts are being made to attain higher credit ratings to attract investors—only possible through financial transparency. With municipalities tapping into the capital market via bonds, the ministry has tied up with an external agency that has culled data of 2,000 current and past balance sheets of a thousand local bodies, to project financial transparency. By 2024, 50 cities are expected to issue municipal bonds.

It doesn’t help either that maintenance of healthy credit ratings, a qualifying criteria for bond issuance, is something that many municipalities are incapable of. Hard-nosed capital market investors are keen on creditworthiness, and understandably so, given the benefits that await upon tapping into the capital markets. But in the absence of reliable disclosures and accounting standards that municipalities in India practice, ease of urban financing awaits. 

Another concern is with adequacy of revenues for repayment. Property taxes, which are a primary source of income for local governments in India, accounted for 0.14% of the GDP, one of the lowest among developing countries. This has partly to do with the lack of local bodies’ autonomy to frame their own tax policies. This is adding to the fact that not a large amount of tax devolution occurs from the centre to the states and further to the municipalities anyway. The pandemic has tightened revenue purses even further. 

According to World Bank reports, SEBI’s guidelines on municipal bonds largely mirror those of the corporate sector, which is in a way inappropriate. By virtue of being listed on the national securities exchange, a number of procedural complications are added to subscribe municipal bonds, even if the qualifying criteria aren’t fairly difficult. But the complications, in a way, disincentivise local bodies from opting for the bond route and turn to banks and other entities instead for investments.

Credit enhancement measures are the need of the hour to improve the local bodies’ profile which will in turn increase bond subscriptions. Agreed, only the Tier I and Tier II cities will come close to raising their prospects if they follow careful fiscal policies over the course of time. As for the remaining cities, sovereign guarantee is the most bankable option. 

SEBI eased a few guidelines to enable municipal bond issuance for smart cities last year. One of the new norms was to allow entities other than municipalities to raise funds too. Entities like urban development authorities or city planning agencies can issue their own instruments now. This is a step in the right direction which could be further improved by making a few more structural changes. 

IRDA Rules in India classify municipal bonds as “non-governmental securities” which mandate at least A+ rating to be eligible for an insurance company’s portfolio. This differential treatment of municipal bonds should be amended, especially in context of long-term investors like insurance and pension funds who would consider municipal bonds a good fit too. 

As of May 2019, India’s municipal bond market is valued at about $200m which is a tiny part of the approximately $1.7trn national debt securities market. Although dwarfed at present, this number could only pick up with increasing market interest and assisted regulation. There was a time when the outstanding debt of US local governments had reached $516m. This might seem like a small figure now but back when it happened in 1870, it was considered a figure tantamount to national shame. Today, the US municipal bond market stands at $3.8trn. We can cultivate the same enduring success too. 

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