Municipal Bond: Definition, Types, Risks, and Tax Benefits

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Governments fund infrastructure and development projects with tax and non-tax revenue. At times, when revenue collection is not sufficient to cover expenditures, the government issues different securities to the public. In India, the central government issues T-bills and bonds, and state governments can access funds via state development loans (SDL). Local government bodies are also permitted to issue bonds, named municipal bonds India.

The 74th Constitutional Amendment in 1992, led to the decentralization of urban local bodies and recognition of the municipal body status. The local government bodies became more accountable to the public, whereas the reform of the financial structure gave them access to financial institutions and capital markets in the following years. Municipal bonds are a result of the same.

Several municipal bonds have been issued so far, and they have become a reliable investment tool for many. Read on to gain a comprehensive understanding of municipal bonds, their types, benefits, and risk factors, and plan your investment with ease!

Defining Municipal Bond

The basic municipal bonds meaning is a bond issued by a municipality or local government body. The funds pooled by municipal bonds are used for socio-economic development in projects like the construction of schools, hospitals, and bridges, providing adequate amenities to households, funding different departments, and so on.

The operational mechanism of municipal bonds is similar to most government bonds. A local government body issues a bond as and when required. Investors can buy a bond and receive interest.

Key Features of Municipal Bonds

Here are the major characteristics that investors should remember while researching municipal bonds.

Tenure

The tenure of municipal bonds can range from 1 year to 30 years, offering convenient flexibility to investors. These bonds are great options for short-term, mid-term, as well as long-term investments, while they are most popular as long-term for long-term benefits.

Pricing

The price of a bond naturally differs from another. It depends on an array of factors, such as the credit rating of the issuing body, industry sector, market trends, interest rates, call provisions, and maturity date. For example, if the interest rates decrease, existing bonds will offer better returns and become more attractive to investors than new bonds issued at the decreased interest rate. So, the price of existing bonds will rise.

Interest Rates

Each municipal bond is issued with a fixed interest rate that remains unchanged through the tenure. For instance, the latest bond was issued by Vadodara Municipal Corporation on March 05, 2024, with an interest rate of 7.9%.

Returns & Periodic Payment

The issuing body uses property and professional tax, revenues generated through specific projects, or both to pay the investors back. The interest is paid on a pre-decided period (semi-annually or annually) throughout the tenure. The principal amount is paid on maturity.

SEBI Guidelines on Municipal Bonds

What are municipal bonds and who regulates them? The Securities and Exchange Board of India has drafted specific guidelines that municipal corporations must abide by!

• The municipality issuing the bond must not have had a negative net worth in the previous three years.
• The municipality must not have any default in the repayment of debt securities and loans that has availed from a bank or a non-banking financial company (NBFC) in the year prior to issuing the bond.
• The municipality or any of its directors and promoters must not be on the RBI-published list of wilful defaulters.
• The municipality must have a credit rating of BBB- or higher, accorded by a SEBI-registered credit rating agency at the time of the issuance.

Types of Municipal Bonds in India

Municipal bonds in India are categorized into two types based on their end-usage.

General Obligation Bonds

Funds collected via general obligation (GO) bonds are used to finance general operations or to improve existing infrastructure. The revenue generated through the general operations is used to pay the investors. These are backed by the creditworthiness of the issuing municipality, making them a relatively safe investment option. The interest rates offered with GO bonds are low in comparison, but the high security and stability serve the interests of risk-averse investors.

Revenue Bonds

Municipal corporations issue revenue bonds to fund specific infrastructure projects like building a road or a hospital. Only the revenue generated from the same infrastructure project is used to pay the bondholders. Since the success of a particular project is responsible for financing the repayments, the revenue-based municipal bonds risk level can be higher than GOs. The chances of default tend to be justified with a higher rate of interest.

List of Municipal Bonds in India

1997 witnessed the first-ever issuance of municipal bonds in India. Bengaluru municipal corporation raised INR 125 crores via the first issuance. The second bond was issued by Ahmedabad in 1998, collecting INR 100 Crores. 

The table below displays municipal bonds issued so far.

Advantages of Investing in Municipal Bonds

The following benefits of municipal bonds make them worthwhile for investors!

Credit Worthiness

Credit ratings for municipal corporations are available from top-rated credit rating agencies like CRISIL. SEBI guidelines make BBB- ratings mandatory for municipal bond issuance, ensuring a certain level of safety for all municipal bonds. Investors can further check and opt for the highest available ratings to ensure maximum security.

Steady Income

As the interest rate remains fixed, the bonds generate returns at the same rate throughout the tenure. The periodic interest payment creates a stable and reliable income.

Portfolio Diversification

Investors with a low-risk appetite find municipal bonds to be lucrative options. That said, high-risk investors can also use these tools for diversifying and balancing their portfolios.

Tax Benefits

Municipal bonds can offer tax exemptions on interest income, provided the investors abide by certain regulations. The capital gain tax applies as per regulations, but the accumulated interest can be exempted from tax.

Risk of Investing in Municipal Bonds

A knowledge of the risks associated with municipal bonds will help investors plan for any unpleasant events.

Liquidity Risk

Bondholders willing to sell the bond in the secondary market before maturity might face difficulties, especially if the issuer is a lesser-known municipal corporation.

Inflation Risk

When the inflation rate goes up, purchasing power decreases. In such a scenario, capital invested in instruments with fixed rates, even though it generates the estimated returns, cannot protect against inflation as the investment value becomes lower than expected.

Interest Rate Risk

The current rate of interest and the bond price have an inverse relationship. In case the interest rate hikes, the price of existing bonds gets a negative impact.

Credit Risk

General obligation bonds are directly backed by the issuing municipal corporation, but the revenue bonds are dependent on respective projects, which may or may not be successful. So, the chance of default, i.e., the credit risk, remains.

Municipal Bonds Investment: Quick and Easy Guide with GoldenPi

GoldenPi has simplified investment in government securities for investors. It is a comprehensive platform with information and updates on all the latest issuance of government securities, including municipal bonds. It further elaborates on all the key characteristics of the securities to make the comparison and final investment decision easy. 

You can invest in municipal bonds in 3 simple steps on GoldenPi!

• Step 1: Start with KYC.
• Step 2: Proceed with bond selection
• Step 3: Complete the investment by making the payment.

FAQs About Municipal Bond: Definition, Types, Risks, and Tax Benefits

1. Are municipal bonds a good investment?

Municipal bonds are issued by municipalities, which are the local government bodies. Since these bonds are backed by the municipalities, the risk level is quite low. They offer a flexible range when it comes to tenures (1 to 30 years). They often generate higher interest rates than savings accounts. These factors are considered, and municipal bonds are good and safe investments.

2. Are municipal bonds totally risk-free?

The risk of default is low in municipal bonds. However, there can be some risk. For instance, revenue bonds can have difficulties paying investors back if the respective sources do not generate adequate revenue.

3. How can I buy municipal bonds?

You can buy municipal bonds on GoldenPi without any hassle. All the details regarding the issues will be mentioned transparently. You can study all the options and select any bond. Once you complete the KYC, you can proceed with the payment.

4. Who owns municipal bonds?

The municipal bonds are issued by municipal corporations. Once investors make the purchase, they become the bondholders and enjoy the benefits until the date of maturity, when the issuer returns the principal amount.

5. Why are municipal bonds more attractive to investors?

Municipal bonds are attractive investment tools because they have low risk and offer steady, periodic interest payments.

6. How to select the best municipal bonds?

Municipal bonds generally have two types: general obligation bonds and revenue bonds. General obligations have lower risk levels than revenue bonds but offer lower rates as well. Select the bond based on your investment goals. People generally opt for municipal bonds when they require low-risk tools. Now the question is how low or at what risk level you need and what your return expectations are. We recommend checking the credit ratings along with other details to ensure the best decision.