Understanding Municipal Bonds in India
As you explore the various options to diversify your investment portfolio, you must have stumbled upon some debt investment schemes. If you are considering investing in a debt investment instrument with very low risk and guaranteed returns, municipal bonds can be a good option. You may ask, what is a municipal bond? Urban Local Bodies (ULBs) like municipal committees and municipal corporations issue bonds to raise funds for various infrastructure development projects. These bonds are known as municipal bonds or muni bonds.
When you buy these bonds you are essentially lending your money to the concerned local body. This money is then used for infrastructure development in your area. And since the local body borrowed the money from you for a certain period of time, you get back your money along with an interest amount as per the interest rate decided at the time of bond issuance. Read on to learn more about municipal bonds and the municipal bond market.
What are Municipal Bonds?
Municipal bonds are debt instruments or bonds issued by Urban Local Bodies (ULBs) like municipalities or municipal corporations to raise funds for their working capital needs or for local development projects that involve infrastructure development work such as building schools, roads, highways and more. By purchasing a municipal bond, you are lending a specific amount of money to the local authority for a predetermined time period. Upon maturity, you get the principal invested along with an interest amount as per the applicable rate of interest. The issuing ULB pays the returns to the investors from the tax collected from taxpayers or the income generated from different development projects.
In India, the Bangalore Municipal Corporation was the first government authority to raise funds by issuing municipal bonds in 1997. However, the muni bonds failed to attract investors and could not build momentum in subsequent years due to the lack of a regulatory framework and the inability to trade them in secondary markets.
Securities and Exchange Board of India (SEBI) issued revised guidelines in March 2015 to revive the municipal bond market in the country. Following the revised guidelines, Urban Local Bodies (ULBs) and local government authorities were able to issue bonds for financing the various infra-development projects. SEBI lays down the guidelines for issuing bonds and revises them periodically.
SEBI guidelines on municipal bonds
- The issuing local government authority or ULB should not have a history of defaulting on debt repayments in the past 365 days of the issuance of a municipal bond.
- The issuing body should have a positive net worth for the past three years prior to the issuance of the muni bond.
- The issuing body and its promoters and directors should not be listed under “fugitive economic offenders” or “willful defaulters”.
- The issuing body must have at least an investment grade credit rating (BBB- or above) given by a SEBI-registered credit rating agency.
The issuing government authorities must follow these guidelines strictly while issuing muni bonds.
What are the different types of municipal bonds in India?
There are two major types of municipal bonds in India- General Obligation Bonds and Revenue Bonds.
General Obligation Bonds
These bonds are issued to raise funds for general development projects in a region. The interest amount for these bonds is paid to the investors from the money collected by the local authorities as property tax and professional tax and through revenues generated from different projects.
ULBs (municipalities and municipal corporations) issue these bonds to raise funds for specific projects. These projects may include building schools, hospitals, roads, water tanks, etc. The revenue generated from the declared projects is utilised to repay the bonds. The projects funded by revenue bonds should open an escrow account. The revenue generated by these projects must be deposited in those accounts.
Advantages of Municipal Bonds
Transparent and governed by regulatory authorities
These bonds are freely traded in secondary markets such as the Bombay Stock Exchange (BSE), and the statements regarding every aspect, such as returns, tenure, and interest rate, are released on the official websites of government authorities. Regulations mandating activities such as these from entities of prominence like SEBI, ensure transparency in the terms and conditions of the issued bonds.
Sebi regulations have enabled monitoring of escrow accounts created for depositing the revenue generated by projects funded through the revenue bonds. So, there is little scope for fraud or hidden conditions that may lead to losses.
Very low risk
Since municipal bonds are issued by ULBs (Urban Local Bodies), they are government-backed, therefore, there is little to no scope for default. SEBI’s guidelines on muni bonds make them even more secure.
The interest earned on municipal bonds is not added to your taxable income. As a result, these tax-free municipal bonds have gained more traction amongst people in the high-income bracket.
Disadvantages of municipal bonds
Long lock-in period and liquidity constraints
The investments in municipal bonds are generally long-term investments. The tenure varies from 3 to 10 years, depending upon the issuing authority. In addition, the lock-in period for these bonds is also longer than other debt investment schemes. So, you may not have access to your money if you need it urgently. Also, some of these tax-free bonds are difficult to liquidate due to the lack of availability of buyers in the secondary market.
Lower interest rates than other debt instruments
The interest rates offered by municipal bonds may seem higher in comparison to what you get on bank fixed deposits, however, they are much lower than what you normally expect from a corporate bond or even a debt mutual fund. The annual interest rate on corporate bonds can be anywhere between 9% to 11%, while municipal bonds usually offer a 7% – 9% interest rate per annum. One benefit that makes these municipal bonds popular among HNIs is that the interest earned on these bonds is exempt from income tax.
Impact of inflation
The effective purchasing power of money reduces with inflation. Suppose you invest in a muni bond for 10 years at a 7.5% interest rate. The rate of interest will remain the same throughout the tenure. However, if the inflation rate reaches the predetermined interest rate, then the value of your money will stay the same even if you are earning interest. In this case, on account of inability to withdraw & reinvest due to the pre-set lock in period – there is no real gain realised on investment.
Who should invest?
If you are interested in investing in local development, you can consider municipal bonds. If a ULB issues bonds for a specific project, you will be very well acquainted with the issuing body, the project for which the bonds are issued, the project’s income potential, and the local government’s credibility. These factors will assure guaranteed returns.
High Net-Worth Individuals (HNIs) who fall in the highest tax bracket can invest in municipal bonds for tax benefits as the interest earned on municipal bonds is tax-free.
Senior citizens looking for risk-free investment avenues and a regular income can also benefit from municipal bonds. Generally, muni schemes pay out the interest on a yearly or bi-yearly basis. This can become a great source of fixed income for risk-averse senior citizens.
Municipal bonds are government-backed debt instruments and are considered a safe long-term investment option. They have become vital tools for raising funds for infrastructure development projects by municipal corporations. As governments are moving towards developing smart cities and infrastructure, the number of projects is expected to increase in the coming years. We can therefore expect more ULBs to issue municipal bonds for raising development funds.
FAQs about Municipal Bonds
How are municipal bonds taxed?
Generally, municipal bonds are not taxed, that is, the interest earned on municipal bonds is not added to your net taxable income. This is why individuals falling in the high income tax brackets opt for these bonds.
What is the grade of municipal bonds?
As per SEBI regulations, municipal bonds issued to the public are investment-grade bonds. This means that they have a credit rating of BBB- or above as vetted by any of the SEBI registered credit rating agencies in the country.
Do municipal bonds carry any risk?
Yes, there is a certain element of risk involved with investing in municipal bonds. However, this risk is minimal as these bonds are issued by Urban Local Bodies (ULBs) such as municipalities and municipal corporations that have government backing.
Is it necessary to obtain a credit rating before issuing a municipal bond?
Yes, as per SEBI guidelines, it is mandatory for the bond issuing authority to obtain a credit rating from any of the registered credit rating agencies. For a municipal bond to be issued to the public, it must have at least an investor-grade rating (BBB- or above).
How can I buy Municipal Bonds in India?
You can buy municipal bonds through bond dealers, banks, brokerage firms and in a few cases directly from the municipality. Further, these Municipal bonds are traded both in the primary market and in the secondary market.