Friday, February 24, 2012

  Municipal Bonds- A case study of Cochin Municipal Corporation

                                                                  By Rohith Jyotish, Intern at Centre for Public Policy Research

A municipal bond is issued by a ULB to raise capital to fund its infrastructure projects. It can be issued by local government bodies that have a strong institutional and economic system. The two key reasons for using municipal bonds are greater fiscal decentralization and effective distribution of funds by the Government of India. Those who want to limit their tax liabilities will buy these bonds. If the returns on these bonds are made tax free, there will be a further incentive for both retail and institutional investors to invest in municipal bonds.  Municipal Bonds can be of two types: General Obligation Bonds and Revenue Bonds. General Obligation bonds have a principal and interest rate that are secured by the full faith and the credit of the issuer. It is usually supported by either the issuer’s unlimited or limited tax power that is future tax revenues are used to service the debt. In the case of the revenue bonds on the other hand, the debt is serviced through the revenues obtained from the project financed through the capital raised from the bond issue.
In India, Ahmedabad Municipal Corporation (AMC) was the first corporation to receive a rating for its general obligation municipal bonds in February 1996. Bangalore Mahanagar Palike (BMP) issued the first municipal bonds in the country worth Rs 125 crore, with a seven year maturity and a coupon rate of 13 per cent per annum.
Since 1994, the Indo-US Financial Institution Reform and Expansion (FIRE-D) project is working with national, state and local governments in India to develop a market-based bond market. As of 2008, the municipal bond market was around Rs 733 crore i.e. 0.2 per cent of the Indian bond market. It has the potential to grow to the tune of Rs 2,000-4,000 crore if infrastructure projects under JNNURM are completed on time (29th September 2009, Economic Times).

Even though the Indian bond market is quite vibrant, the municipal bond market is still in its nascent stage. It is still much better than those in some other developing countries.
S. No.
Type of Bond
Amount (Rs. in Millions)
Taxable bonds
Tax-free bonds
Pooled finance

Source: Market Based Financing of Urban Infrastructure in India by Chetan Vaidya and Hitesh Vaidya (2007)
Over the years, several ULBs have raised over Rs 12,316 million in taxable bonds, tax-free bonds and pooled finance.

Pooled Finance Development Fund

For a municipal corporation to issue bonds, raise capital and not be caught in a debt trap, it must have a strong institutional framework, a growing economy and a widening tax base. But only the relatively larger municipal corporations would be able to finance their projects through the issue of tax free bonds. Most small and medium urban local bodies are not able to access the financial and capital markets simply on the basis of their budget balances. The cost of transactions is also a significant issue.

So, in the Tenth Five Year Plan, a Pooled Finance Development Fund (PFDF) of Rs 400 crore had been set up. According to it, every state was required to set up a state pooled finance development fund to implement the government’s finance mechanism. If this were properly utilized, ULBs may get a better entry into the bond market on a regular basis. According to the Report, 5 per cent would be used for project development assistance. The rest would be used for a special fund to strengthen credit ratings of municipal bonds. But unfortunately, Karnataka and Tamil Nadu are the only two states that have successfully raised capital through the pooled finance route. It has been unsuccessful in India due to the distrust among investors towards MCs due to inefficient bureaucracy, corruption, political interference, lack of accountability, long gestation periods, etc. Another reason is the lack of a reliable credit-rating mechanism and the difficult methodology involved in rating. There’s a distinct lack of information on funds raised through municipal bonds and there’s a fear of not getting the investment back on maturity.

The bond issues should have a regulatory framework. The Indian municipal bond market is curtailed due to regulatory restrictions on investments by long term investors like insurance companies and pension funds. Banks prefer assets of a shorter duration.

Credit Rating
A strong credit rating mechanism will go a long way in increasing the quality of choice of debt instruments whether it’s a bond market, a pooled finance vehicle or a commercial bank loan. It will ensure market discipline by better financial planning among ULBs and fiscal prudence and greater efficiency in their operations. It provides a non-objective assessment of the risk of default on bond issue. It increases the transparency and enables the investors to choose easily. It also makes the ULBs more accountable for their actions as it shows the ability of the local bodies to manage their fiscal balances. This would be especially relevant for KMC as it lacks transparency in its publication of data about the progress or completion rates or cost of recovery of various projects undertaken. In addition to credit rating, agencies should take steps to monitor the bond issuers to make sure that their payments of principal and interests are regular.

In the case of corporate and federal bonds, the Indian bond market is fairly developed because it has one of the highest bond issuances in Asia. So addition of a municipal bond will diversify the quality of bonds available in the market. Retail investors of high net worth and institutional investors will be able to diversify their portfolios and municipal bonds would be quite similar to the treasury bills in terms of risk profile as the issuer is a government body. Even though the regulatory mechanism under the Securities and Exchange Board of India (SEBI) is fairly efficient, we do not have a Municipal Regulatory Board like in the US to specifically regulate the Municipal Bonds Market. Until it’s established, SEBI will have to take charge of regulatory duties. For the municipal bonds to be successfully introduced in the current political scenario  in India, myths about financial markets should be removed and awareness has to be spread about the functioning of municipal bonds so that bond issue is not taken advantage of by partisan politicians to gain political mileage.

Since 1997, all major credit rating agencies like CARE, FITCH, ICRA and CRISIL have provided ratings for municipal bond issues. Under JNNURM, the Ministry of Urban Development has directed these rating agencies to rate all cities brought under JNNURM. 62 cities have been rated till January 2010. 50 corporations have received investment grade ratings.

The following table gives some of the major corporations and their ratings:
Rating Category
No of Cities
Key Credit Factors

Greater Mumbai, Navi Mumbai, Nashik, Surat, Pune and Thane
Cities in this category exhibit robust debt coverage ratio, have strong finances, adequate managerial, technical and institutional abilities, healthy economic base and generate consistent revenue surpluses.
Nagpur, Kalyan, Rajkot, Vadodara, Mira Bhayanadar, Ahmedabad, Kolkatta and Chandigarh
Cities in this category generally have comfortable financial risk and favourable economic base.
Panaji, Indore, Dehradun, Faridabad, Nanded, Bhopal, Kochi, Ajmer, Ludhiana, Trivandrum, Jaipur, Chennai, Coimbatore, Madurai and Mysore
Cities in this category have a weak financial profile, high dependence on government grants/transfers and weak project implementation abilities.
Meerut, Asansol, Guwahati, Ujjain, Shimla, Howrah, Ranchi, Jammu, Jabalpur and Amritsar
Cities possess marginal/negative operating surpluses thereby limiting ability to borrow and service additional debt
Bodhgaya, Jamshedpur, Varanasi and Haridwar
Cities have inadequate and volatile grant support from State Government; poor economic base and adverse financial profile marked by poor collection efficiencies.
Source: “Municipal Credit Rating-Evolution and Implications for Urban Sector Financing (Draft), prepared for NIUA March 2010 by Sujath Srikumar

So, according to the this table, Kochi Municipal Corporation has a weak project implementation ability, a weak financial profile and a high dependence on central government transfers and grants.

 Municipal Bonds in Other Developing Countries
Developing countries have been able to attract foreign equity capital for private infrastructure investments. But debt financing has been a tough task especially for the local bodies. Since local markets may be too small, urban local bodies may have to resort to borrowing for foreign markets. Foreign exchange resources can only act as a complement to existing domestic resources as total dependence on it may not be a sustainable funding source for all urban local bodies for their infrastructure projects. In some cases, external funding may add penalties to borrowing costs.

All countries mentioned here have a severe infrastructure problem:
·         South Africa: The bond market in South Africa is much older than that of any other developing country. The Rand Water Board has issued bonds since the 1920s and they continue to do so today. The maturities of these bonds are around 25 years. This is under-developed primarily because under the ‘apartheid regime’, large shares in portfolios of institutional investors were to be made in government investments. Now the government is trying to extend the reach of its financial markets in the areas where the majority of the population is black.

·         Poland: The Polish bond market is dominated by government debt instruments with a maturity period ranging from 52 weeks to 5 years. Corporate bond issuance has gained momentum very recently. Revenue bond issues have been sold by municipal-owned enterprises. Only about 2 percent of local government capital spending derives from borrowed funds and most of it comes from banks or subsidized funds from government. The Polish government is now exploring options to raise funds because of demands from potential investors and issuers. A first step was taken in the form of a law that came into effect in August 1995. An over-the-counter securities market was established in late 1996.

·         The Philippines: Treasury Bonds and Notes dominate the debt markets in the Philippines. The maturity period range up to 7 years. Private issue of bonds is comparatively less. Only a few municipal issuers have sold bonds. The best known among them are the Cebu Equity-Bond Units, sold in 1991 by the Provincial Government of Cebu. The bonds, with two-year maturities, were backed by a pledge of repayment from a joint public-private consortium that paid off the principal with equity shares in the corporation. Municipal bond activity is virtually non-existent.

·         Indonesia: The government does not issue bonds. Certain corporations and banks have been involved in bond issues. Maturity periods have ranged from 5 years to 12 years.

So, it is fairly evident that these countries are trying to establish municipal bonds market by first strengthening their financial markets. All these efforts are said to have modeled on the US municipal bonds market.
Source: Accelerating Municipal Bond Markets by James Leigland, Regional Housing & Urban Development Office for East Asia.


  •   If infrastructural projects are to be implemented properly, first a proper draft of the Kochi City Development Plan should be made that does not contradict in terms of the priorities given to various projects and areas under consideration.
  •   Detailed Project Reports (DPRs) of the phases of the projects completed so far should be sent so that funds for the next phase are released.
  •   The general belief among potential investors is that the bureaucracy at the corporation level is inefficient, marred by corruption, lacks proper financial management skills, has many vacancies in key posts and also lacks accountability. Only if reforms are undertaken to reduce the inefficiencies associated with project planning and implementation can the KMC move ahead in its infrastructure development agenda. Only then can it legitimately vouch for additional financial support through bond issues for major projects like the Metro Rail.
  •   Kochi Municipal Corporation is said to have no shortage of funds from various sources. Most recently, from lending agencies. But lending agencies are willing to lend money only because there is a state government guarantee. Since the financial management of KMC is in bad shape, more and more borrowing through lending agencies will only accentuate the fiscal crisis of the State Government of Kerala.
  •   To mitigate the problem of excessive dependence on the State and Central Governments for funds, financial markets can be tapped through municipal bonds.
  •  Municipal bond market develops as a part of the bond market in India which is not under the control of the local governments and that which requires prudent macro-economic policies. Hence before resorting to municipal bond issues, hyper-inflation must be kept in check so that real returns are not meagre.
  •  A genuine municipal bond issue should not have a state or central government guarantee as it will create a lax attitude in the implementation of the infrastructural projects undertaken from the capital raised through the bond issue as the bond issuer is not entirely made responsible to pay back the debt. This will eventually add to the public debt at the central and state levels. It will create a situation that is similar to what has been happening over the past few years when local bodies have been raising funds through credit lending agencies hence rendering the whole argument for municipal bond issues pointless.
  •       A city or a town issuing municipal bonds must have an efficient system of service delivery, sound institutions and good fiscal relations with the centre and the state. This implies transparent city budgets, credible accounting systems and independent audits.
  •   A reliable regulatory mechanism should be put in place. In case municipal bodies default, bankruptcy laws must be defined properly to ensure that the creditor’s claims over municipal assets are well-defined.
  •    Appointment of credit rating agencies will help in the non-objective assessment of the creditworthiness of the various municipal bond issuers. Credit rating agencies assess the creditworthiness by analyzing the ability of municipal bodies to raise revenues through taxes and other sources, their ability to honour financial commitments, their dependence on central and state government transfers and loans, etc. To improve the credit standings, municipal tax bases should be expanded and tax rates should be rationalized. For example, the stamp duty in Kerala is a bit too high because of which there’s a high rate of default. If this rate is brought down, the rate of default should go down and there would be revenue buoyancy.
  •    A municipal bond with a low credit rating will be priced at a higher spread than the normal central government bonds and treasury bills. Hence, a bad credit rating might incentivize corporations to raise infrastructural and bureaucratic efficiency so that their credit rating is improved and more investors invest in their municipal bonds.
  •  —  To reduce the cost of debt issue, a bond insurance market can be contemplated. But it should not be a substitute for the creditworthiness of a bond issuer. Bond insurance market if formed should be brought under the purview of the Insurance Regulatory and Development Authority (IRDA) of India so that markets are not taken advantage of by certain players. For a successful bond insurance market to exist there should be a large variety of debt instruments present in the market to ensure diversity along with a reliable credit rating mechanism to respond to the investors who are conscious of the credit ratings. In the US, around 50 per cent of the municipal bond issues are insured.
  •   Setting up a benchmark coupon rate on municipal bonds should not depend on that of the sovereign bond issues and instead should reflect the market conditions as sovereign issues are backed up by a guarantee and they’re comparatively short-term.
  •  —  Municipal development funds can be set up to provide credit to municipal entities. Such an initiative was taken by the central government when it set up the Pooled Finance Development Fund.
  •      Municipal Bonds should be made available tax free so that retail investors are incentivized.


 It can be concluded that the Kochi Municipal Corporation suffers from a lack of proper financial management rather than lack of finances. If the above mentioned recommendations are followed step by step, KMC’s fiscal position could be improved so that in the future, it does not have to depend on central or state government transfers to implement its various provisions and projects.

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