What are Municipal Bonds?
Municipal Bonds or Muni Bonds are bonds issued by local government bodies or Municipal Corporations. Bangalore was the first city to issue municipal bonds in India in 1997. Later, Ahmedabad followed by launching its municipal bonds in 1998. The funds raised by these municipal bonds are used for constructing bridges, parks, schools, and other public projects. Are these bonds safe? When should one invest in these bonds? What are the risks associated with these bonds? Let’s find out.
Why Do Local Bodies Need Bonds?
Urban Local Bodies, like municipal corporations, public townships, etc. have always had a lack of funding and resources. According to a 2018 report by NITI Aayog, “The total revenues of all Urban Local Bodies (ULBs) in India amount to less than Rs 1, 50,000 crores, approximately, 1% of India's GDP.”
Most of the municipal corporations rely on grants or budget allocated by state governments or the central government. Apart from these, they rely on water supply bills, property taxes, octroi, rents from municipal properties, vehicle registration fees, etc. The municipal bodies also had the responsibility of promoting socio-economic development in their areas. However, these are not sufficient to set up new projects or maintain already existing projects. To address this problem, local bodies started issuing municipal bonds.
How Good Are Municipal Bonds?
- Tax Free Income- Municipal bonds are usually tax free or taxed at a lower rate. It is advisable to check the placement memorandum and necessary paper work before investing in a bond.
- Lower Risk - Municipal corporations of big cities set up projects like metro rails, public transport, roads, flyovers, public parking spaces, garders, redevelopment schemes, housing schemes. These big municipal corporations are likely to recover the money that they spent. Such development is seen only in Tier-1 and Tier-2 cities and generally gave a credit rating above A- going up to AA+ which is actually good.
On the other hand, municipal bonds of smaller towns and cities tend to have lesser development projects in hand and therefore might depend on tax collected to pay back their bond holders. This means that the returns might get riskier for smaller municipal corporations. These bonds have a credit rating lower than BBB+.
- Strict SEBI Regulations- SEBI guidelines have assured that only those municipal bodies can issue bonds which are financially stable and have the ability to pay back their bondholders. You can read the official SEBI guidelines for municipal bonds over here.
- Lower Default Rate - Municipal Bonds on an average have a default rate of 0.18% as compared to corporate bonds that have a default rate of 3%. This means that municipal bonds are more likely to pay back an investor’s money.
How Risky are Municipal Bonds?
- Long Maturity Period - Most Municipal Bonds are issued for 10 years and generally start paying out after the 4th year from the date of issue. This means that Municipal Bonds may not be the best idea for those wanting to invest short term.
- Lower Returns - Municipal bonds offer lower rate of return than corporate bonds due to various reasons like limited revenue base, tax base and risk factors.
- Call Risk - Like how companies ‘buy-back’ shares, bonds are ‘called’ back. Companies do so when the bond yield decreases and they want to increase the yield to attract more investors. When these bonds are ‘called’, it pays the bond holders the face value of the bond and the interest accrued on it. This can cause the bond holder to loose potential interest or pay more taxes on the amount received.
- Dependence on Third Parties - Municipal projects aren’t the cleanest in nature. There is a lot of corruption and third parties(contractors) involved who may try to cut corners on the projects. Whether or not a project is completed depends on the company to whom the project was tendered to.