Municipal bonds offer one creative financing solution

By Hemant Sahai and Anjan Dasgupta, HSA Advocates

The capital requirements for developing smart cities over the next two decades are staggering. While some funding will be available from the central and state governments and urban local bodies (ULBs) for the initial investments to upgrade core infrastructure, this will be inadequate in the context.

Hemant Sahai
Hemant Sahai

The preferred corporate implementation structure that is emerging for smart cities envisages nodal planning, developmental and execution authorities in the form of special purpose vehicles (SPVs) created as limited liability companies under India’s Companies Act, 2013, promoted jointly by the respective state governments and the municipalities (or ULBs). Since not all infrastructure projects in the smart cities can be rolled out on a public-private partnership basis, and budgetary support will be limited, the SPVs/ULBs will need to raise additional capital. Municipal bonds are being viewed as a promising source of alternative funding for smart city infrastructure.

As the municipal bond market in India is still nascent, opportunities in overseas capital markets are also being explored. Given the growing need for private finance in infrastructure projects and the potential for municipal bonds to bridge this gap, the Securities and Exchange Board of India (SEBI) on 15 July issued the SEBI (Issue and Listing of Debt Securities by Municipalities) Regulations, 2015. Under the regulations, municipalities (as established under India’s constitution) and entities set up as subsidiaries of municipalities under the Companies Act are permitted to issue non-convertible debt instruments.

Municipal bonds could either be revenue bonds, where interest and principal are serviced through revenues from one or more identified projects, or general obligation bonds, where interest and principal would be serviced through tax revenue collected by the municipalities. The regulations state that only revenue bonds with a tenor of three to 30 years and minimum investment grade rating can be issued to the public. The issuers in such cases would need to have a positive net worth for the preceding three years and should not have defaulted on repayment of any debt securities or loans to banks or other financial institutions during the preceding year.

For revenue bonds issued to the public, an escrow account must be set up to channel project revenues for debt servicing and the minimum subscription must be at least 75% of the issue size. Revenue bonds and general obligation bonds can also be issued on a private placement basis and listed on a recognized stock exchange if the minimum subscription amount or investment is at least ₹2.5 million (US$38,000) per investor, and the bonds are rated by at least one credit rating agency.

Anjan Dasgupta
Anjan Dasgupta

The funds raised from a public issue can be used only for projects that are specified in the offer document and the issuer will be subject to monitoring and auditing. For both public and private placements asset cover sufficient to discharge the entire principal amount is required; misstatements in the offer documents are prohibited; security is required for secured bonds, and state or central government guarantees or structured payment mechanisms are required for unsecured bonds.

These regulatory developments will help deepen the municipal bond market in India as well as create a secondary market for municipal bonds, and consequently provide an alternative source of funding for smart cities and other urban infrastructure projects. Foreign institutional investors will be entitled to invest in these listed bonds. It is further expected that over time and with experience, the ULBs will be able to approach overseas capital markets.

Some basic issues are still unresolved and must be addressed by the government in order to realize the full potential of municipal bond financing in India. A number of public agencies have large funds, which are typically invested in government bonds and securities. They have not opened up their investments to alternative debt securities like municipal bonds. Individual retail investors also have traditionally only invested in term deposits, savings schemes and provident funds. To instil confidence in the market and encourage investment from public agencies and individual retail investors, the central government should provide tax and other incentives and should consider guaranteeing these bonds until the municipal bond market matures.

The government is already considering legislative reforms to provide certainty to investors in case of bankruptcy and defaults on payment of interest and principal by debtors. Along with legal reforms, the governance levels of municipal bodies must be improved. The government should ensure that the SPVs set up to implement the smart cities programme have qualified personnel from the public and private sectors so that these SPVs have technical and financial expertise. This will in turn help improve the credit
worthiness of these SPVs. Capacity building of individuals leading these organizations is vital for long-term performance and improving service levels at the municipal level.

HSA continues to advise diverse stakeholders on legal and structural issues in the development of financing models for infrastructure development.

Hemant Sahai is the managing partner and Anjan Dasgupta is a partner at HSA Advocates. HSA is a full-service firm with offices in New Delhi, Mumbai and Kolkata, and with a correspondent relationship in Bangalore.

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