What are Municipal Bonds?

A municipal bond refers to debt instruments issued by municipalities. Bonds issued by Indian municipalities, known as muni bonds, play an important role in funding local projects. Municipal bond examples include constructing schools, hospitals, and highways. In this article, you can understand municipal bonds’ definitions, types, SEBI guidelines, advantages, and disadvantages. The maturity period of these bonds is three years. Municipal corporations provide returns through property and professional taxes collected or by generating revenue from specific projects.

Key Highlights

• Municipal bonds are debt instruments issued by municipalities in India. These bonds are used to fund local projects such as the construction of schools, hospitals, roads, and other infrastructure developments.

• According to the guidelines of the Securities and Exchange Board of India (SEBI), it is compulsory to have a positive net worth and a minimum triple B credit rating for issuance to the public.

• The two main types of municipal bonds are general obligation bonds (fund general projects) and revenue bonds (fund specific projects).

• Before investing in these bonds, investors should gain knowledge about the credit quality, broker fees, and other factors.

Understanding Municipal Bonds

Municipal bonds act as a debt instrument. These bonds are mostly issued by municipalities or other associated bodies. Municipalities raise funds through these bonds to finance projects for socio-economic development, including bridge construction, schools, hospitals, and proper amenities for households. The maturity period of these bonds is three years. Municipal corporations provide returns on these bonds either by collecting property taxes or by generating revenue from specific projects.

Types Of Municipal Bonds in India

After understanding the municipal bonds, let’s now understand the types of municipal bonds in India. The two main types of municipal bonds are:

General Obligation Bonds

The purpose of general obligation bonds is to raise capital for general projects, such as improving a region’s infrastructure. Bond repayment and interest are paid through revenue generated by various projects and taxes.

Revenue Bonds

Revenue bonds are issued to raise funds for specific projects, such as the construction of a building. The principal and interest on such bonds shall be repaid through revenues generated from the projects specifically declared. Whenever revenue bonds are used to finance projects, the revenue generated shall be deposited in an escrow account.

Who Should Consider Municipal Bonds?

Here’s a list of individuals who should consider investing in municipal bonds:

• Long-Term Investors: Municipal bonds can be suitable for long-term investors because they prefer to do investments with a fixed maturity period like three years or longer. 
• Risk-Averse Investors: Investors who want stability and capital preservation can invest in muni bonds. These bonds are safe because they are backed by the local government. 
• Income-Focused Investors: Investors who want regular and tax-free income from their investments can invest in these bonds. The interest generated from muni bonds is free from taxation. 

What are the SEBI Guidelines on Municipal Bonds?

SEBI has mandated the following new guidelines:

• A municipal bond should have a net worth positive over the last three years before it is issued.
• There should be no names of municipal entities, their group companies, directors, and promoters in the list of willful defaulters published by the Reserve Bank of India.
• A municipal bond can be issued to the public if it has a rating of triple B (BBB) or above, as sanctioned by the top credit rating agencies in India. These ratings establish the credibility of the bonds and thus increase the confidence among investors in these bonds as they authenticate and popularise them.

Advantages Of Municipal Bonds

Investing in municipal  bonds has multiple advantages, including:

Transparency

Municipal bonds provide high transparency because they are regulated and have strict disclosure norms. 

To help investors make informed decisions, issuers are advised to provide detailed financial statements and project information. 

Tax Benefits

Tax-free municipal bonds are available in India for investors who adhere to certain rules. Additionally, interest rates generated on such investment tools are exempt from taxation.

Minimal Risk

As these bonds are backed by the local government, they have minimal risk as compared to other bonds. Additionally, their regular revenue stream from taxes or other project-specific profits improves their safety for investors. 

Diversification

Diversification benefits are provided if you include muni bonds in your investment portfolio. This diversification will also help in reducing risks. 

Disadvantages Of Municipal Bond

Listed below are the two main disadvantages of these bonds:

Long Maturity Period 

For municipal bonds, three-year lock-in periods are very common. This can sometimes be a liquidity burden on investors.  If an unpopular municipal corporation issues the bonds, it can be difficult to sell them prematurely in the secondary market. Due to uncertain credibility and yielding capacity, entities are hesitant to invest in such cases.

Low-interest Rate

The interest rates on these bonds may be higher than those on other debt instruments, yet they are considerably lower than those on market-linked financial instruments such as equity shares. Investors seeking the best municipal bond should consider different variables such as their risk appetite, investment objectives, investment portfolio, etc., in tandem with the credibility of the municipal body and the credit rating of the bond.

Risks and Considerations

The following are the risks involved in municipal bonds: 

• Credit Risk: This is very rare to face but yes there is credit risk in municipal bonds. There is a possibility that the bond issuer might fail to make the required interest payments or the principal amount to the bondholders.
• Liquidity Risk: This kind of risk is common in municipal bonds. Compared to other government bonds, municipal bonds have lower trading volumes, thereby making it challenging to find a buyer in the process of selling.
• Interest Rate Risk:  As the interest rate moves it can have a critical effect on municipal bond. When interest rates rise, newly issued bonds will have a higher interest, while existing lower interest-bearing bonds will be less attractive.
• Regulatory Changes: Market dynamics and investor returns can have a major impact on the bonds when there are changes in the rules and regulations.

Factors to Consider When Investing in Municipal Bonds

In addition to the risks, there are certain factors too that you need to consider before investing in municipal bonds:

• Broker Payment: For the payment of brokers a markup over the cost of the bond to the firm is used. This markup may be included in the confirmation statement. If a commission is charged, it will be reported on your confirmation statement. It’s important to ask your broker about the markups and commissions.
• Credit Quality: Investors need to understand a bond’s credit quality because credit quality is important in understanding whether a bond is suitable for an investor’s strategy.  Investor should discuss this with his/her broker. 
• Tax Implications: To discuss the bond’s tax implication you can take guidance from a tax professional. They can provide personalised advice on how these bonds may impact your overall tax liability and help you maximise potential tax benefits.

Conclusion

Bonds issued by municipalities or their associated bodies in India are called municipal bonds or muni bonds. A municipal bond is used to fund projects like roads, airports, railway stations, schools, etc. India generally issues two types of municipal bonds: general obligation bonds and revenue bonds. Additionally, these bonds provide transparency, minimal risk, and tax benefits. A low interest rate and long maturity term are some of its downsides. Before investing in these bonds it is important to consider the factors and risks involved with them.

FAQs on Municipal Bonds