It was in 1997 that Bangalore city corporation issued the first municipal bond in India, backed by a state government guarantee. The next year, Ahmedabad issued bonds worth Rs 100 crore, without government guarantee. But the momentum didn’t pick up – bonds worth only about Rs 1500 cr have been issued overall since then, and there have been no issues in the more recent years.

Last June, however, Pune Municipal Corporation (PMC) became the first city to issue bonds after a long gap. Bonds worth Rs 200 cr were issue to fund PMC’s 24X7 water supply project.

Then again, in February 2018, Greater Hyderabad Municipal Corporation (GHMC) also issued bonds worth Rs 200 cr for its Strategic Road Development Project (SRDP). Recently, there have been a spate of news reports, indicating that many more cities are planning to issue bonds.

What are municipal bonds?

Like regular bonds, municipal bonds are debt instruments. Here the issuer (that is, the municipality) raises funds from investors, which it should then repay to the investors at a specific interest rate, on a specific schedule.

The bond could be a general obligation bond where repayment is guaranteed by the municipality’s overall revenue, or else a revenue bond which is issued for funding a specific project and repaid with revenue from that project. Municipal bonds are commonly used by cities in US and China to finance their infrastructure.

The push from the Centre

The resurrection of municipal bonds in India is largely thanks to the push by the central government. It’s been clear for a while that Indian municipalities can no longer depend on state and central government grants alone, which have traditionally been their biggest revenue sources.

As opportunities in rural areas remain low, migration to urban areas would multiply manifold. Hence cities need to rapidly improve their infrastructure to deal with this population influx. According to a High Powered Expert Committee set up by the Ministry of Urban Development (MoUD) in 2011, the investment needed for urban infrastructure from 2012-2031 would be about Rs 39 lakh crore (at 2009-10 prices).

Central programmes like Smart City Mission (SCM), AMRUT and SBM have stressed the need for financial independence of municipalities. The centre has also urged cities to get credit ratings that are necessary for bond issue. While credit rating of 500 cities under SCM and AMRUT are progressing, the ratings of 94 of them – given by agencies like CRISIL and India Ratings & Research – were released in March 2017.

The  ratings span 20 levels from AAA to D, with BBB- being investment grade rating; cities rated below BBB- have to get better ratings to attract investors. Only 55 of the 94 cities had investment grade ratings. Ratings were based on multiple criteria like the cities’ social and economic profile, operating efficiency, policy framework, recent financials etc.

While none of the cities got the highest rating of AAA, three cities – Pune, Navi Mumbai and NDMC (New Delhi Municipal Corporation) – got the second highest rating of AA+. GHMC, Ahmedabad and Visakhapatnam got the next best rating of AA, and four other cities were rated AA-. Overall, only 10 cities were rated in the AA band. And only 14 came under the next ‘A’ band.

In 2015, SEBI brought about new regulations for issuing bonds. It lays out many criteria for municipalities to issue bonds, such as not having negative net worth in any of the previous three years.

Bonds on the anvil

While many municipalities were expected to issue bonds in 2017-18 itself, most are yet to decide.

Pune and Hyderabad corporations, which got good response from the market, are planning to issue more bonds. PMC’s initial Rs 200 cr issue is part of a larger scheme to issue bonds worth Rs 2200 cr for its water supply project. The interest rate for the initial bond was 7.59%, much lower than that of other sources like HUDCO loans.

Ulka Kalaskar, Chief Accounts and Finance Officer at PMC, says, “The interest rate for HUDCO loan is 9.1%. Also it requires corporation assets to be pledged as security, unlike in the case of municipal bonds.” She says PMC may not issue bonds in 2018-19 as there are enough funds for the project for now.

Road in Hyderabad city. Pic: Wikimedia Commons

In GHMC’s case, the interest rate is much higher than PMC’s, at 8.9%. The reasons for the higher rate are that GHMC’s credit rating is lower than that of Pune. Also, interest rates had in general gone up in the country by the time of the GHMC issue. Hyderabad plans to raise another Rs 800 cr through bonds for its road development project, but has not yet decided on when. While Pune’s water project is revenue-generating, GHMC’s SRDP isn’t.

In the case of both bonds, repayments should be completed within the bond maturity period of 10 years. SEBI regulations require bonds to be secured by municipal assets or be backed by a state government guarantee. Else they should follow a structured payment mechanism, wherein they regularly deposit repayment amounts in a separate escrow account. Both Pune and Hyderabad have opted for structured payment mechanism; their bonds are not secured and don’t come with a government guarantee.

As per a Business World report, NDMC is soon planning to raise Rs 200 cr through bonds, to strengthen its electricity distribution network. But Navi Mumbai corporation, rated highest alongside NDMC, has no plans. Its commissioner Dr N Ramaswami says the corporation currently has surplus funds from property tax and GST refunds, and hence doesn’t need to issue bonds.

While top-rated municipalities are making quick decisions, lower-rated ones like Ahmedabad, Surat and Kochi are still contemplating. Ahmedabad – rated AA like Hyderabad – is planning to raise a total of Rs 800 cr. Ahmedabad Commissioner Mukesh Kumar says that bonds worth Rs 200 cr will be issued annually for the next four years.

“One of these will be a ‘green municipal bond’ for biomining of the Pirana solid waste dump site. The site, active since 1980, has 80 lakh metric tonne of solid waste, and we plan to clear it within 5-6 years. Other bonds are to close the gap of Rs 400-500 cr in the funding of Ahmedabad’s Smart Cities Mission,” said the Commissioner. Of Ahmedabad SCM’s total outlay of Rs 2400 cr, about Rs 2000 cr is expected to come from government grants and PPPs, and the rest from bonds.

The corporation, however, is awaiting a policy decision from the centre to either make municipal bonds tax-free, or to give the cities an interest subsidy of 2%. “We have sent this proposal to the MoUD. Currently our interest rate for bonds will come to about 8.5%, but we already get loans from other sources at lower rates. Municipal bonds will be viable for us only if the rate comes down to 7%,” says Kumar.

Since the Finance Ministry had declined to give tax-free status to municipal bonds, the MoUD had announced  last year that it would give interest subsidy to cities issuing bonds. But this has not been implemented yet.

Surat is postponing its bond issue, as its current credit rating of AA- will lead to higher interest rates again. M Nagarajan, CEO of Surat Smart City Development Ltd says that the corporation is not considering bond issue in 2018-19. “If Surat’s credit rating was AA+, interest rates would be lower and viable. If we are issuing bonds, it should cost us lower than other financing options including PPP.” Nagarajan says that the city is planning to improve its ratings, and may issue bonds after getting a better rating.

The much lower-rated Kochi corporation (BBB) is preparing a DPR (Detailed Project Report) on bond issue, and has not made a decision yet, says corporation Secretary A S Anuja.

Are municipalities ready for bonds?

“The irony is that municipalities that are already financially strong and have higher credit ratings – like Pune, NDMC and Hyderabad – are the ones who will find investors. This is because those investing in these bonds are pension funds, insurance funds etc, who are risk-averse and generally don’t invest in any bond rated below AA,” says Devendra Kumar Pant, Chief Economist at India Ratings & Research.

Pant opines that pooled financing may be a good option for lower-rated cities. In pooled financing, many municipalities come together to issue one bond collectively, and pay back from the revenue from their projects collectively. Pant says that the Tamil Nadu Urban Development Fund (TNUDF), which facilitates pooled financing, is a good model. “Karnataka had followed this model to fund its municipalities’ water projects, but it has not taken off in other states like Rajasthan that attempted it,” he says.

CRISIL estimates that municipalities will raise Rs 15,000 cr overall by 2023 from multiple sources, out of which Rs 6000 cr is likely to be raised through municipal bonds within the next three years. Amit Bhave, Director at CRISIL says, “For ULBs, municipal bonds offer the flexibility of longer tenures, and annual interest payments at fixed rates, compared to bank loans. The capital market also has a large investor base, and hence can be more competitive than bank borrowing.”

However, given the poor governance of municipalities currently, the majority have a long way to go before improving their credit ratings.

A major issue is that cities’ property tax collections – their main revenue source – are extremely low, mainly due to low coverage of properties and poor collection efficiency. For example, as per a report by the Vidhi Centre for Legal Policy, two-thirds of Bengaluru city corporation’s total revenue in 2015-16 came from state and central government grants; only one-third was the city’s own revenue from taxes and user charges. As municipalities rely more on government grants, there’s also greater government interference in municipal affairs.

Even in the case of municipal bonds, in most states the final approval is given by the state government as per its discretion. This was the case with the Hyderabad and Pune bonds too. The Vidhi report points out that most municipalities don’t have a debt limitation policy that lays out specific criteria for borrowings. In this scenario, state government approvals could be based on political consideration rather than actual need, and could also be time-consuming.

“State governments should develop a strong regulatory framework for municipal bonds, which will bring about more transparency and risk assessment for both investors and the municipalities. The success of municipal bonds is linked to the devolution of power from state to municipalities,” says Alok Prasanna Kumar, co-author of the report and Senior Resident Fellow at Vidhi.