By Sunil K. Parameswaran
Municipal bonds or ‘Munis’ are a very popular type of fixed income securities in the US. These bonds are debt securities, issued by local governments, or municipalities in the US. They are likely to become more popular in India as time goes by. In the US, there may be about two million Muni issues outstanding at any point of time. Consequently, there could be issues pertaining to liquidity. That is, people who seek to sell such bonds may face issues in locating suitable buyers at a mutually acceptable price.
State government bonds
Municipalities are government entities like the central or federal government of a country and its state governments. Consequently, they cannot issue equity shares. Thus, bonds represent the only securities they can issue to fund their expenses. To augment taxes, tolls, and other sources of income, municipalities therefore regularly issue bonds. Unlike central governments, which can always print more money, municipalities cannot. Consequently, these governments can always default on debt. Of course, in practice, it is likely that the concerned state government will bail it out, if there were to be issues pertaining to the repayment of such bonds.
Also, holders of such bonds may get some tax relief on the incomes earned from such securities. In the US, governments operate on the principle of mutual reciprocity. Federal government securities are exempt from state income taxes, while state government securities are exempt from Federal income taxes. At times, for the residents of a state, the security may be exempt from both taxes, making it effectively a tax-free security. Also, income tax paid to the state government in the US, is a tax- deductible expense while computing the federal tax liability for the year.
Munis may be General Obligation Bonds (GO bonds) or revenue bonds. The former are backed by the taxing power and other regular incomes of the municipalities, while the latter are backed by the revenue of a specific project. For instance, if a municipality is building an airport, or a railway station, or constructing a new expressway, it may opt to issue bonds backed by the projected revenues from the project. Rating agencies who rate such bonds will be very conservative.
The normal policy is to scale down the projected revenues, and scale up the predicated expenditure, by a factor, and then assess whether the project is still financially viable. For instance, a Muni issuer may have projected that 2.5 million passengers will use the airport every year. The rating agency may project a reduced footfall of 1.5 million passengers and assess whether the project is financially viable.
Municipal bonds are likely to take off in a big way in India. With today’s free market philosophy, municipalities will find it difficult to levy taxes beyond a point. Central and state governments too will expect such entities to raise their own funds. Muni issues are a logical solution.
The writer is CEO, Tarheel Consultancy Services