This article is written by Vivek Maurya from ICFAI Law University, Dehradun. In this article, the author has discussed municipal bonds and their regulation in India.
Table of Contents
Introduction
Municipal bonds (or ‘munis’ for short) are mortgages issued by provinces, cities, districts, and other government agencies to finance day-to-day obligations and to fund major projects such as school construction, highways, or wildlife systems. By buying municipal bonds, you are actually borrowing money from a bond provider for the purpose of obtaining a regular interest rate, usually annually, and a return on your initial investment, or ‘principal’. The municipal maturity date (the date on which the issuer of the bond returns the money to the principal) maybe years to come. Short-term bonds mature in one to three years, while long-term bonds will not mature for more than ten years.
Generally, interest on municipal bonds is not taxed by the organization’s rates. Interest may not pay state and local taxes if you live in the province where the bond is issued. Bond investors generally want a consistent distribution of payments and, compared to stock investors, can be riskier and more focused on saving, rather than maximizing wealth. Given tax benefits, interest rates on non-taxable municipal bonds are generally lower than fixed-income securities, such as corporate bonds with similar maturity, credit attributes, and other factors.
In addition, municipal borrowers sometimes issue bonds on behalf of private companies, such as non-profit colleges or hospitals. These ‘ditch’ borrowers usually agree to pay the donor, who pays interest and heads on the bonds. In cases where the channel borrower fails to pay, the supplier usually does not have to pay the shareholders.
History of municipal bonds in India
The Bangalore Municipal Corporation became the first city council to issue municipal bonds in India back in 1997, although the first major success came in 1998, when Ahmedabad introduced the public release for the first and only time. However, the municipal bond market remains volatile, with the proposed ₹ 2,000cr ($ 268m) raised from ten issues so far. Municipal bonds lost ground after the first investors attracted and failed to raise the required amount of money. To renew municipal bonds, the watchdog market Securities and Exchange Board of India (SEBI) came up with guidelines for issuing municipal bonds in 2015.
SEBI restructured the eligibility mechanisms for 2015 in order to make the following major changes:
- The municipality must not have a negative rate each year for the past three years.
- The municipality must not fail to repay mortgages and loans obtained from banks or non-bank financial institutions in the past year.
- The municipality, the promoter, and the directors must not be registered with the Reserve Bank of India (RBI). The municipality should not have a record of default and the principal’s payment in respect of debt instruments.
Present scenario regarding municipal bonds
Indian municipalities are gradually increasing their financial independence and establishing their own municipal bonds. Recently, Ghaziabad became the tenth city in India to raise municipal bonds and fortunately, the first city to grow green bonds (expanded to meet environmentally sound infrastructure).
Funds collected from these commitments are used by local government agencies to fund socio-economic development projects. On 2 December 2020, Lucknow Municipal Corporation (LMC) bonds became the first municipal bonds from North India to be listed on the Bombay Stock Exchange (BSE). The listing event was attended by Uttar Pradesh Chief Minister Yogi Adityanath. With this list, Lucknow became the ninth city in India to issue municipal bonds and the first city to issue such a bond after the introduction of the Atal Mission For Rejuvenation and Urban Transportation Scheme.
Municipal bonds as a way to raise money for the municipalities
India’s infrastructure sector has the potential for ‘strong growth, attractive opportunities, policy support, and profitable investment’. In view of this, there is a plan for the budget and cost of USD 1.4 trillion for infrastructure between 2019 and 2023 to support the sustainable development of the cities within the country. There are many ways in which a new government has been introduced to start this process. For example, the most recent is the government’s proposal to establish a new DFI (Development Financial Institution), to fill a key long-term funding gap.
Infrastructure projects are often characterized by high dynamics and long periods of pregnancy, which often lead to financial instability. Therefore, strengthening the bond market and public investment is an effective and necessary solution. Continuing to achieve this goal is the need to invest private investment in infrastructure and public services to accelerate the devastating impact of the economy. The potential consequences of this combination will include full growth and enhancement of business and individual prospects.
When examining the reasons for better infrastructure, the most obvious is the rapidity of the city of different regions in the country. This includes investments in all categories, including municipal levels. The issuance of municipal bonds or munis by municipal companies to raise funds for community projects, such as building roads, bridges, schools, or other infrastructure, is important. Refunds from munis are then refunded from the capital generated by such activities or tax revenue.
To correct the negative rate of municipal bonds, the Department of Housing and Urban Development compiled the details of the annual audited accounts in accordance with local international standards for the first time. These efforts are being made to obtain high debt levels to attract investors – the only possible financial possibility. As municipalities enter the capital market through bonds, the department has partnered with an outside agency that collected data on 2,000 current and previous sheets from 1,000 local bodies, with the aim of making things more financially transparent. By 2024, 50 cities are expected to issue municipal bonds. To date, eight local bodies in India have raised Rs 3,390 crore in this way.
Under the ‘Smart City’ government program, special purpose vehicles are established at the city level in a corporate manner limited under the Companies Act, 2013 to implement projects. They are promoted by the state government or the union area and the body of the urban area. As mentioned above, the amended regulations will also allow for the collection of funds through muni bonds by special purpose vehicles (SPVs) set aside to implement the activities of smart cities. In the event of privatization, the minimum investor registration fee is currently set at Rs 25 lakh but has now been reduced to Rs 10 lakh to comply with the rules of business obligations. The move could simplify and strengthen the muni bond market and boost investor confidence in urban development.
Regulatory framework for a municipal bond market in India
The SEBI has issued regulations that will assist in the disbursement of municipal debt and the listing of debt shares in Indian municipalities in March 2015 (amended 2017). This will enable investment in the public infrastructure of the 100 smart cities that the Government of India (GOI) is proposing to build. The SEBI Regulations (Issue and Listing of Debt Securities by Municipality), 2015 (amended in 2017) define the appropriateness, terms, and conditions of social issues, including employment, credit rating, minimum registration, accounting, auditing, and reporting requirements, and other disclosures, etc. Key features of the SEBI (Documents and Credit Protection List by the Municipality), 2015 (amended 2017) are:
- Debt protection listing issued by public issuance of privately deposited in a known stock exchange.
- The qualifying municipality itself or through Corporate Municipal Entity (CME) may increase the number of municipal bonds. CME means a company defined under the Companies Act, 2013, which is a company owned by a municipality and established for the purpose of raising funds for a municipality or a particular group of municipalities. The regulation states that CME, its promoter, corporate company, or directors should not have been deliberately listed in the defaulters published by the RBI or should not have failed to pay interest or refunds in respect of debt instruments provided by the public.
- Under public issuance, monetary bonds will have a lower investment rate.
- A provider that makes a public issuance of municipal bonds will only issue revenue bonds. If kept private, the provider can issue both standard bonds and income bond bonds.
- The grantor will create a separate escrow account for the use of municipal bonds at a specified rate. The provider will appoint a monitoring agency such as government financial institutions or banks nationally set up to monitor the amount deposited in the escrow account.
Investors attraction towards municipal bonds
Apart from tax exemption, municipal bonds are an attractive investment for investors in the following ways:
Predictable income
Most municipal bonds pay interest twice a year, so by default. You know exactly how much to expect and when to get it. Also, with the maturity date specified, you know when to return your principal to the issuer.
Historically low chance of default
Municipal bond payments are typically backed by taxes or user fees from services that are often essential. This helps reduce their potential for missing interest and principal payments.
Opportunity to invest your money locally
If you buy municipal bonds issued in your country, you may have more information about the issuing municipality or become better acquainted with funded projects. As a result, you can make better decisions about what obligations the municipality is free to buy.
Taxations and returns
Indian municipal bonds enjoy tax exemptions if investors comply with the rules, and the interest rate depends on how well the markets are doing. Bonds can be issued publicly or privately. SEBI allows local urban bodies to increase funding for development projects by issuing revenue bonds. Revenue bonds are those bonds from which the money is used for a specific project. The proceeds from this project are used to pay off bond investors.
The interest rates offered by these bonds are currently at an all-time high of more than 8%. These are long-term bonds with a term of 10 years but if you buy them from the secondary market, the current yield is in the range of 7.25% to 8%. At the moment, while the fixed-rate bank offers about 6% interest, the interest rate of 8% is very attractive. The green bonds of the Gaziabad Municipality are listed on the BSE Bond platform on Thursday. The municipal organization has increased 150 crores by private placement. The bond offers an attractive rate of 8.1%. However, it is lower than the 8.5% rate offered by municipal bonds in Lucknow.
Benefits and importance of municipal bonds
Importance of Municipal Bonds Market
- Municipal Bonds can help urban local bodies (ULBs) raise funds to complete budget projects as property taxes are the only major source of municipal revenue.
- The growth of the municipal bond market is important in major cities and India to improve their creaking infrastructure.
- The ability of municipal livelihoods is also critical to the success of the institute’s pet projects such as smart cities and Amrut.
Benefits of Municipal Bonds for Investors
Transparency
Municipal bonds issued to the public are rated by reputable agencies such as CRISIL, which allows investors to be transparent about the reliability of the investment option.
Tax benefits
In India, municipal bonds are exempt from taxation if the investor complies with certain rules. In addition to such assurances, the interest rates generated on those investment instruments are also exempt from tax policy.
Low risk
Municipal bonds issued by municipal authorities, including the minimal risk involved in these storms. Government bonds are often regarded as low-risk investments because the chances of the government failing to repay its loans are starting to decline.
Risks involved with investing in municipal bonds
As with any investment, investing in municipal bonds poses a risk. Investors in municipal bonds face many risks, including:
Call risk
Telephone risk means the credit provider’s ability to repay the loan before its maturity date, something the provider can do if interest rates fall – just as a homeowner can keep a mortgage loan to benefit from lower interest rates. Bonds are less likely to have a stable interest rate or a higher interest rate. Most municipal bonds are ‘expensive’, so the investors who want to bind the municipality’s obligation to maturity should research the terms of the bond calls before buying.
Credit risk
There is a risk that the mortgagee may face financial difficulties that make it difficult or impossible to pay interest and the principal in full (failure to pay interest or principal is called ‘payable’). Credit ratings are available on most bonds. Debt ratios seek to estimate the risk of an equitable bond liability compared to other liabilities, although the higher rate does not indicate a prediction that the bond has no chance of default.
Interest rate
Bonds have a fixed face value, known as ‘par’ value. If the bonds are kept to maturity, the investor will be reimbursed for the face value, as well as interest that can be set at a fixed or floating rate. The market price of the bond will rise as interest decreases and will decrease as interest increases so that the market value of the bond is higher or lower than the equivalent price. The U.S. interest rate It’s been down for a while. If they go up, investors with low municipal collateral and who try to sell before maturity may lose money due to the low market value of the bond.
Currency risk
Inflation is a normal movement that goes up in price. Inflation reduces purchasing power, which is detrimental to investors who earn a fixed interest rate. It can also lead to higher interest rates and a lower market value of existing bonds.
The danger of liquid
It refers to the risk that investors will not find a viable market for the municipal bond, which could prevent them from buying or selling when they want and receive a certain amount of bond. Many investors buy municipal bonds to hold them rather than sell them, so the collateral market may not be particularly liquid, and quoted prices for the same bond may vary.
Other challenges faced by municipal bonds
In addition to risks, there are other challenges facing municipal responsibilities:
Tax effects
Consider consulting a tax professional to discuss the effects of the bond, including whether your bond may be subject to a different state tax or be eligible for state income tax benefits.
Merchant Compensation
Many retailers are compensated for marking more than the bond costs of the firm. This mark can be disclosed in your confirmation statement. If a commission is charged, it will be reported on your verification statement. You should ask your dealer about markups and commissions.
The background of the seller or consultant selling the bond
A security dealer must be licensed, and, depending on the nature of the business, the company must be registered with Municipal Securities Rulemaking Board (MSRB) and Financial Industry Regulatory Authority (FINRA), Security and Exchange Commission (SEC), or the state security regulator.
Conclusion
With the rapid urbanization of people and economic activities, the challenges of urban infrastructure are also increasing in India. Urban infrastructure is traditionally provided by ULBs, whose financial situation is not very stable for a variety of reasons. Another way to continue the delivery of infrastructure services without financial disruption is the adoption of market tools such as municipal bonds, supply of project resources and project revenue can be used to pay.
Past experience with municipal bonds in India shows that they achieved the goal until the 2004 coup d’état. Municipal bonds had eased since 2004 with the formation of a new UPA-led government. There are very few bonds issued between 2005 and 2014. As the NDA government returned to power in 2014, it is hoped that there will be a re-launch sector. The government has already announced Municipal bonds as a tangible tool to finance urban infrastructure projects, especially in the construction of ‘Martin Cities’, thus restoring good hopes for them.
Therefore, it can be concluded that municipal bonds can play a role in financing infrastructure development in smart cities and participate in the new development agenda to build ‘100 Smart Cities’. However, in order to be able to repay bond loans, some changes must come to ULBs, especially at the institutional level in financial management, projects, organization, and people, so that the development of the delivery side will improve outcomes.
References
- https://www.livemint.com/money/personal-finance/three-things-you-should-know-about-municipal-bond-listings-11618164002568.html
- https://www.investor.gov/introduction-investing/investing-basics/investment-products/bonds-or-fixed-income-products-0
LawSikho has created a telegram group for exchanging legal knowledge, referrals, and various opportunities. You can click on this link and join:
https://t.me/joinchat/J_0YrBa4IBSHdpuTfQO_sA
Follow us on Instagram and subscribe to our YouTube channel for more amazing legal content.
