The municipal bond market in India has been marked by very modest borrowing levels, which have stagnated over the past few years. One of the possible reasons for this could be the availability of ‛soft money’ route for project financing through flagship programs of the government like JNNURM. The bigger and better-rated municipalities have sufficient sources of funds and are reluctant to enter the debt markets.
First Part of the two part series – Municipal bond market in India
Other lower-tier and mid-tier municipalities have no access to bond markets and mostly rely on state-owned Housing and Urban Development Corporation for their funding needs. Hence, capacity building is the biggest hurdle for the municipal bond market in India.
Broadly, the constraints in the municipal bond market in India can be classified as those on the supply and those on the demand side. The constraints on the supply side inhibit ULBs from issuing bonds and those on the demand side limit investors (individual and institutional) from participating in the municipal bond market. On the supply side, the absence of buoyant sources of revenues for ULBs increases their reluctance to borrow. The demand for these bonds is low as they are believed to be relatively illiquid instruments. This is mainly due to a missing secondary market for these instruments, which result in investors having to hold municipal bonds until maturity.
Further, Pension Fund Regulatory and Development Authority (PFRDA) classify municipal bonds as Class C instruments instead of Class G that is limited only to government securities. Municipal bonds, thus have to compete with other Class C instruments, which may have higher yields than municipal bonds. This makes municipal bonds unattractive within this asset class.
The interest-rate limitation of 8 percent pertaining to the tax exemption of municipal bonds creates no incentive for investment in this sector. Despite having an investment grade rating, ULBs do not have easy and cheap access to finance as they are still considered to be riskier than the corporate with the same rating. This is because the credit rating of an ULB depends on the State’s financial position as most of the ULBs depend upon the devolution of resources and grants from the State governments. In case the financial position of the states is not perceived to be sustainable, it may lead to unpredictability of transfers from State governments to ULBs and hence may impact the outlook of financial position of ULBs.
The budgeting and accounting systems of ULBs still lack transparency, except in a few big ULBs. This leaves scope for misappropriation of assets and misleading picture of income and expenditure of ULBs. Further, there is no specific statute which governs the insolvency aspect of ULBs like the corporate. Thus, an absence of a well-defined legal remedy against ULBs may be a potential reason for low demand for the bonds.
Suggestions and Way Forward
There is a need for capacity building of ULBs in planning capital investments and financial management, including sound accounting and budgeting systems to tackle the supply-side constraints.
Increasing the marketability of the bonds so that retail investors can be brought into the market. This can be done by including the bonds under “EEE” taxation scheme, where the initial investment, the interest earned and the maturity amount are all exempted from taxation. Further, introducing flexibility in setting the interest rate cap (currently 8 percent) for issuance of tax free municipal bonds is needed.
Municipal bonds could be given the status of ‘public securities’ so that they become admissible for statutory liquidity ratio (SLR) investment by commercial banks. The urban infrastructure sector could also be included as a priority sector for the purpose of lending. This is expected to increase the demand for municipal bonds from institutional investors.
Introduction of a bankruptcy law applicable to urban entities and regulatory support to develop a secondary market for municipal bonds, which will allow for arbitrage opportunities, balancing portfolios and asset-liability management may increase the demand for these debt instruments.
Improving transparency and disclosure norms to increase investor confidence. Offer document should disclose all the information regarding the management, administration, Financials, operations, projects, revenue generation, risk factors etc. to the public along with the future revenue generating capacity of the ULB.
Need to encourage establishment of Bond banks, which collect all the borrowing needs of municipalities and issue a single class of bond backed by a diversiﬁed portfolio of borrowers. This arrangement reduces investor risk and lowers the borrowing costs of the local governments. Bond banks have been used extensively in Canada and the United States since the 1970s.
Creating a secondary market for bond trading is another means of tapping into long-term savings. The existence of a secondary market allows households or institutions to sell their long-term bonds before maturity. Such flexibility increases the market demand for long-term securities.