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What Are Municipal Bonds?

Writer # Indiabonds | November 30, 2022

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Local governments issue municipal bonds to raise funds for public projects like schools, hospitals, bridges etc. Bonds are loans that an investor makes to issuers. On purchase of a bond, an investor receives regular pay-out of interest and the amount is redeemed when the bond matures. However, liquidity in muni markets is not that high when compared to government and PSU bond issuances due to their limited outstanding issuances.

What is a Municipal Bond? 

Municipal corporations or associated bodies that issue bonds in India are known as municipal bonds or muni bonds. To assist Urban Local Bodies (ULBs) or local government bodies in raising funds from muni markets, SEBI changed the guidelines related to their issuance in 2015. 

Local government bodies issue these bonds to finance developmental activities such as building bridges, schools, and hospitals, providing proper amenities to homes, and other socio-economic projects.  A municipal corporation provides returns on these bonds from different sources, such as property and professional taxes collected, or revenue generated from specific projects.

Types of Municipal Bond

There are two types of municipal bonds: general obligation bonds and revenue bonds. Each of them is described here:

General obligation bonds

The public sector uses general obligation bonds to fund projects that do not necessarily make a profit, such as building parks or improving schools – things that do not generate profits directly but benefit the communities they serve. 

An issuer of general obligation bonds will assure that their obligation is fully backed by their creditworthiness, which means that bondholders will not be forced to repossess any specific asset of the issuer. 

This has led to general obligation bonds being regarded as one of the safest types you can purchase.

Revenue Bonds

Municipalities issue revenue bonds to finance revenue-generating projects, such as toll roads and concert halls. 

This project will generate cash for investors, which will be used to pay interest and the principal is repaid at maturity. Revenue bonds are more risky because they are used to complete specific projects, which can be delayed and run over budget. 

Researching the credit rating of the issuer in these cases is essential for avoiding capital risk.

Who should invest in Municipal Bonds?

Municipal bonds or muni bonds subscribe to a credit rating before issuance. This determines their ranking in safety. An investment in high-rated bonds can be considered a safe option as an investment. As a result, it is suitable for investors who do not have a high level of risk tolerance, as these investors tend to seek more security from their investments. These bonds also offer portfolio diversification and other benefits of investing in fixed income like stable and regular income. 

The interest rates offered by these bonds are higher than those provided by other forms of debt. Bonds such as these may be of interest to investors seeking capital appreciation as the developmental projects progress. However, the value of these bonds can fluctuate due to changes in interest rates and credit worthiness of the issuer.  

Pros of Municipal Bonds

Several advantages can be derived from investing in such bonds, including the following:

Integrity and transparency

Ratings of these bonds are provided to investors by renowned rating agencies such as CRISIL etc, giving investors greater transparency regarding the credibility of the issuer.

Tax-free status

It is possible to obtain an exemption from taxation for municipal bonds in India if the investor complies with specific requirements. In such cases, interest income from municipal bonds are exempt from taxation.

Low risk

As muni bonds are issued by government bodies, they have implied (although not guaranteed) support from state governments. Hence, they are deemed to be safer.

Cons of Municipal Bonds

These bonds are disadvantageous in the following ways:

A long maturity period

Bonds issued by municipalities always have longer tenor.

Liquidity

Liquidity in municipal corporation bonds may be challenging at times due to their smaller outstanding as well as credibility of issuer. Sometimes development of projects also determines value of the underlying bond. Investors may find that holding the bonds to maturity may be the best option in such issuances.

Conclusion 

Municipal bonds are a good investment option given their higher yield. However, investing in the best municipal bonds involves considering several factors such as investment objectives, risk appetite, investment portfolio, etc., as well as the credibility of a municipal body and the bond’s credit rating to determine its liquidity and repayment ability. Investors should conduct adequate due diligence on issuer and its credit ratings before making investment decisions.

FAQs

1. Is it safe to invest in municipal bonds?

High-rated municipal bonds offer a safe investment compared to other debt investment options. As a result, there is lower risk of default. In other words, these bonds do not come without some risk, as it is entirely possible that the issuer will not be able to pay the interest or the principal at maturity. 

2. Are there any cities in India that have issued municipal bonds?

Several cities in India have issued these bonds over the years, such as Pune, Hyderabad, Indore, Amravati, Bhopal, Visakhapatnam, Ahmedabad, Surat, Ghaziabad, Lucknow, and others. 

3. Is it worth it to buy municipal bonds?

Investing in these bonds can be an effective way to protect your capital while at the same time generating higher interest on it. The investment of a high credit-rated bond is one of the safer investments. However, the risk of default on a bond investment is something you should keep in mind when investing in bonds for weaker credits.