Both the central and state governments rely on tax and non-tax revenue to fund infrastructure and development projects across the nation. When there is a shortfall in this revenue, they issue various securities to gather funds and cover their expenditure needs. Among these securities, municipal bonds are commonly used by government bodies to raise funds in India.

What Are Municipal Bonds? 

A type of debt securities, municipal bonds are issued by local government bodies to finance daily operations and infrastructure projects like schools, highways, water supply and sewerage systems. They provide a safe and reliable investment option due to their government backing. 

When you buy a municipal bond, you are lending money to the government and, in return, receive regular interest payments over a specified period. By the end of this period, the bond gets matured and the government returns your initial investment. 

First Municipal Bond in India 

After the 74th Constitutional Amendment, municipal bonds were first issued in India in 1997. Following this, urban local bodies were decentralised, given autonomy and made more accountable to citizens. By reforming the financial structures, this issuance enabled them to access capital markets and financial institutions.

Bengaluru  municipal corporation issued the first municipal  bond in India, raising Rs. 125 crores in 1997. A year later, Ahmedabad issued bonds worth Rs. 100 Crores in 1998.

SEBI Guidelines on Municipal Bonds

The Securities and Exchange Board of India (SEBI) has formulated specific regulations and guidelines, concerning municipal bond issuance in India. Here are some of the guidelines that issuing entities must meet to raise funds through municipal bonds:

• The local government authority or urban local authority (ULB) issuing the bond must not have a track record of defaulting on debt repayments within 365 days before the issuance of the municipal bond.
• The issuing entity's net worth must be positive for three years before issuing the municipal bond.
• The issuing entity, along with its promoters and directors, must not be listed as ‘willful defaulters’ or ‘fugitive economic offenders’.
• A credit rating of at least BBB- or higher from a SEBI-registered credit rating agency should be held by the issuing entity. 

Characteristics of Municipal Bonds

Municipal bonds are financial instruments that come with unique features and characteristics, setting them apart from other types of investments. Here are some of the key characteristics of municipal bonds that you need to know:

• Municipal bonds are debt securities through which investors lend money to government bodies. 
• These bonds are issued by the government to fund public projects for the benefit of the community. 
• Upon maturity, the government repays both the initial investment made through these bonds and the accrued interest. 
• The returns from municipal bonds, which finance government projects benefiting the public, are generally exempt from taxation.
• Most municipal bonds offer higher interest rates than savings accounts and money market accounts.
• Municipal bonds tend to have a lower default rate than corporate bonds.
• While stocks can be quickly bought and sold on exchange platforms, municipal bonds are less liquid and more challenging to trade.

Types of Municipal Bonds

There are primarily two types of municipal bonds, each having its own set of distinct features and risk profiles. Let us discuss these two types of municipal bonds in detail. 

1. General Obligation Bonds 

General obligation bonds, often known as GO Bonds, are issued by municipalities to finance general operations such as the construction of schools or roads. 

These bonds are generally regarded as the safest option as they are backed by the creditworthiness of municipal corporations. The interest payment of these bonds comes from the operational revenue of municipal corporations. These bonds offer lower interest rates but with more stability, make them an ideal choice for risk-averse investors.

2. Revenue Bonds 

Revenue bonds are used to finance specific infrastructure projects like the construction of hospitals and airports. Unlike GO bonds, these bonds are backed by the revenue generated by the projects, such as tolls, fees or charges from the project usage. 

Its dependence on project revenue makes these bonds riskier, as the bond payments depend on the success of the projects. To compensate for the higher risk, revenue bonds usually offer higher interest rates, attracting investors looking for potentially greater returns.

Municipal Bond Duration

Municipal bonds can have a maturity period from one year to thirty years. During this time, municipal entities pay regular interest, either semi-annually or annually. The interest is paid with funds from property and professional taxes, revenue from specific projects or a combination of both. Investors can choose the duration according to their investment horizon and financial goals. 

Municipal Bonds Interest Rate

Most municipal bonds offer a fixed interest rate that remains constant till the bond's maturity. On the other hand, its price might vary in the secondary market based on the fluctuations. 

When interest rates drop, newly issued municipal bonds offer lower yields compared to existing bonds, making the older bonds more appealing. As a result, the price of older bonds increases. Alternatively, newer bonds offer higher returns than older bonds when the interest rate rises. In such cases, their price decreases. 

How Are Municipal Bonds Priced? 

The market price of municipal bonds is determined based on various factors, including credit rating, interest rates, industry sector, market trends, call provisions and maturity date. For instance, the bond's market price tends to rise as the interest rate decreases. As a result, the market value of such bonds can be either higher or lower than its par value.

List of Municipal Bonds in India

Here is a table outlining the details of municipal bonds issued in India.

Municipal Bonds Tax Benefits

In India, certain municipal bonds qualify for tax exemption, but it depends on the type of investors, type of bonds. The tax free status could be a big benefit for high tax slab investors. 

Municipal Bonds Advantages and Disadvantages

Municipal bonds are a popular investment option known for their tax benefits and low-risk nature. However, like any investment, they come with their own set of advantages and disadvantages that investors should consider before making decisions. Let us first dive into the advantages of investing in municipal bonds. 

Advantages of Investing in Municipal Bonds 

Municipal bonds offer a range of advantages that make them an appealing investment option. Some of these advantages are discussed below:

• Credit Worthiness: These bonds are rated by prominent credit rating agencies in India like CRISIL, which offers investors valuable insights into their creditworthiness.
• Low Risk: Since issued by municipal authorities, these bonds generally indicate a low level of risk. 
• Tax Benefits: Municipal bonds come with tax exemptions, allowing investors to keep more of their earnings.
• Diversification: By investing in Municipal Corporation Bonds, investors can diversify their portfolio and lower the overall risk of their portfolio, which comes from high risk instruments like corporate bonds. 

Disadvantages of Investing in Municipal Bonds 

While municipal bonds offer several advantages, they also come with certain drawbacks. Let us delve into the disadvantages of investing in municipal bonds:

• Lock in Period: Average maturity period of municipal bonds in India is between 3 to 10 years, and due to their lock-in period, selling municipal bonds prematurely in the secondary market can be challenging, particularly if they are issued by lesser-known municipal entities. This can lead to concerns about their credibility and potential yield, further restricting liquidity for investors.
• Low Returns: These bonds offer returns that are lower than those generated by market-linked instruments. Municipal bonds cannot serve as a strong hedge against inflation as stocks do. During an inflationary period, the fixed income from such bonds becomes less appealing to investors.
• Market Sensitive:  Returns from municipal bonds are significantly influenced by fluctuations in interest rates. If interest rates increase, the market prices of existing bonds tend to drop, potentially resulting in lower returns for investors.

Final Word 

If you are interested in tax benefits and contributing to the nation’s progress, investing in municipal bonds can be an ideal choice for you. First, you need to ensure that bond investments align with your overall financial goals. Lastly, make sure to evaluate the issuing entity's creditworthiness and assess your risk tolerance before prioritising any investment.