Boost your portfolio and community with municipal bonds explained.

Municipal bonds, or “muni bonds,” have become key players in India’s urban development, with 12 municipal corporations raising ₹4,584 crore between 2017 and 2023. Given the World Bank’s projection that India needs to invest $840 billion in urban infrastructure by 2036, muni bonds offer a crucial avenue for funding. Curious about what municipal bonds are and how do they work? Find out in this blog.

What are municipal bonds?

In essence, a bond is a contract between a lender and a borrower. When you buy a bond, you’re lending money to the bond’s issuer in return for periodic interest payments and the face value of the bond being returned when it matures. Businesses and governments regularly issue bonds to raise money. 

Now, narrowing down to municipal bonds, these are special types of bonds issued by municipalities or local government bodies. Municipal bonds, as opposed to corporate or government bonds, are designed expressly to fund public initiatives such as the construction of roads, schools, and other infrastructure that is necessary for socioeconomic growth.

How do municipal bonds work?

The unique aspect of municipal bonds lies in how they promise to pay back the investor. The earnings from the projects these bonds finance or the taxes the issuing municipality collects are usually the sources of these bonds’ returns. 

Also, various municipalities use different approaches to ensure bond repayment. Tier 1 municipalities frequently have surplus money, which makes it simpler for them to meet their financial obligations. However, Tier 2 towns set aside a percentage of their cash receivables to guarantee they can pay their future obligations.

Municipal bonds in India

The Bengaluru Municipal Corporation (BMC) issued the first municipal bond in India in 1997. The Ahmedabad Municipal Corporation swiftly adopted this measure in 1998. As a result, cities such as Hyderabad, Pune and other municipal corporations began to issue their own municipal bonds

India’s municipal bond markets have not performed as well as anticipated. To stimulate the country’s municipal bond market, the Securities and Exchange Board of India (SEBI) published revised guidelines in March 2015. 

But current patterns suggest that India is becoming more and more interested in municipal bonds. In a significant move, NSE Indices Limited, a subsidiary of the National Stock Exchange, introduced the Nifty India Municipal Bond Index in 2023. This is the country’s first municipal bond index featuring investment-grade ratings. It tracks the performance of municipal bonds issued by various Indian municipalities across different maturity periods, currently it holds 28 muni bonds from 10 different issuers.

SEBI guidelines for muni bonds

SEBI has set specific rules for municipal bonds to make sure they’re a safe option for investors. Here are some major points from the guidelines: 

•  The municipality must not have had a negative net worth in the three years leading up to the bond issuance.
• There should be no defaults on repayment of debt securities or loans from banks or NBFCs in the year prior to issuing the bond.
• The municipality’s group companies, promoters, and directors must not be listed as wilful defaulters by the RBI nor listed under “fugitive economic offenders”.
•  Municipal bonds must have a credit rating of BBB or higher from top credit rating agencies in India, such as CRISIL, to be issued to the public.

Types of municipal bonds India

• General obligation bonds: 

These bonds are intended to raise money for large-scale initiatives like park or road improvements that benefit the entire community. The general tax revenue that the municipality receives is used to pay back these bonds. 

• Revenue bonds: 

These are given out for particular undertakings, such as constructing a water treatment facility or a new school. The intriguing aspect of this situation is that the funds needed to repay these bonds are derived directly from project earnings.

 For instance, the toll revenue from a toll road would reimburse bondholders if a bond was issued to fund its construction. The funds from these projects are often kept in a special account supervised by financial institutions to ensure there’s enough money to pay back the bond.

Benefits of municipal bond in India

• Investing in municipal bonds has several benefits, one of which is the tax exemption on interest earnings.
• Municipal bonds provide a fixed and regular interest payment, offering a stable income stream.
• Municipal bonds are more accessible to ordinary investors as well as institutional ones due to their smaller issuance sizes.

Drawbacks of municipal bonds

• Municipal bonds may have lower yields when compared to other investment options like corporate bonds or stocks.
• A lot of municipal bonds have lock-in periods that might last more than three years, which limits investor liquidity.
• Municipal bonds have a default risk because they are not centrally guaranteed like certain other bonds, yet they are still preferable to corporate bonds.

Bottomline

Municipal bonds present a special chance to fund community development while enjoying tax breaks and steady revenue. They do, however, carry some risks, including the possibility of lower yields and liquidity issues. Understanding their features and risks is key to making informed investment decisions.

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