Led by the profitable minority, India's urban municipalities are readying to flood the debt market with the newest on the investor's menu: the muni-bond. Perhaps you should buy 'em. 

By Dilip Maitra

They're muni-bonding. Unbelievable as it may seem, India's scared-n-scarred investors are actually placing their confidence--and their cash--in the least likely destination of public money: municipal corporations. And the trickle--a Rs 125-crore issue of 8-year bonds by the Bangalore Municipal Corporation in September, 1997, followed by a Rs 100-crore issue of 7-year bonds by the Ahmedabad Municipal Corporation in January, 1998--could turn into a tide.

At least half-a-dozen other municipalities are preparing to enter the capital markets with municipal bonds (a.k.a. muni-bonds). After Bangalore (No. 1 on The Best Cities 1998, BT, December 22, 1998) and Ahmedabad (No. 8), the aspirants are concentrated in Maharashtra: the Mayors of Nashik (No. 18) want Rs 100 crore; Jalgaon, Rs 200 crore; Aurangabad, Rs 50 crore; Sholapur, Rs 50 crore; and Pune (No. 5), Rs 200 crore. And Hyderabad (No. 3) wants Rs 100 crore too. Among the other revenue-surplus municipalities considering such issues: Vadodara (Gujarat); Visakhapatnam (Andhra Pradesh); Chennai, Coimbatore, and Tirupur (Tamil Nadu); Hubli (Karnataka); Ludhiana, Jullandhar, Chandigarh, and Amritsar (Punjab).

The muni-bond is here, Mr Money Manager. Just watch the reaction. Despite a low coupon-rate of 13.25 per cent--compared to the fixed deposit rate of 14.50 per cent at that time--the Bangalore Municipal Corporation's Rs 75-crore issue was oversubscribed by Rs 50 crore, which it retained. And the Ahmedabad Municipal Corporation's Rs 100-crore issue, marketed under the Citi Bonds brandname, was fully subscribed too. Crucially, unlike the Bangalore Municipal Corporation, the Ahmedabad Municipal Corporation raised Rs 25 crore from retail investors. Agrees Sujatha Srikumar, 35, Deputy General Manager & Head (Infrastructure Projects), Credit Rating Information Services of India Ltd (CRISIL), which rated the Ahmedabad Municipal Corporation's issue: "I am quite sure that muni-bonds have a large market."

Really? Who would lend money to those insidious, corruption-ridden, slothful, inefficient, bureaucratic labyrinths that pass under the name of municipal corporations? No one. But, incredible as it may seem, there are a handful whose fiscal fitness is awesome, implying high levels of operational efficiency, uncompromising cost-management, and a business-minded approach. For instance, the Ahmedabad Municipal Corporation generated revenues of Rs 421 crore in 1997-98, with an enviable operating surplus of Rs 60 crore, while the Nashik Municipal Corporation had a surplus of Rs 82 crore in 1997-98 on revenues of Rs 173 crore.

That the municipalities can do with all the cash they can raise is obvious. Traditionally, urban infrastructure projects have been financed by grants from the state governments and loans from the financial institutions, like the Housing & Urban Development Corporation (HUDCO) and the Life Insurance Corporation. But, with the budgetary support of the Centre and the states to urban municipalities having declined by 20 per cent in the last 10 years, it is clear that the money must come from elsewhere. Says D.N. Vaidya, 55, the Municipal Commissioner of Aurangabad: "Given the declining grants from the state governments, municipalities will have to depend on market borrowings." Echoes K. Rajivan, 43, CEO, Tamil Nadu Urban Development Fund: "Municipalities have little choice but to raise their own resources."

Just how big can the muni-bonds market be, then? In the US, where they are more than 60 years old, muni-bonds account for 80 per cent of the bonds market, amounting to $1.10 trillion (Rs 46,75,000 crore) in 1998. Till that year, 50,000 of the 83,000 municipalities in the US had used the instrument to raise funds. Tracked by armies of analysts with Wall Street investment bankers and security traders, muni-bonds are considered to be one of the safest options for the risk-averse, conservative investor.

In fact, the returns they offer are shorthand for safety-plus-assurance. In 1997, the Lehman 5-year Muni-bond Index and the Lehman 10-year Muni-bond Index appreciated by 6.40 and 9.20 per cent, respectively, compared to the 24.80 per cent generated by the Dow Jones Industrial 30 or the 33.30 per cent offered by the Standard & Poor (S&P) 500. But change the period to 10 years (1987-1997), and while the muni-bond indices returned 7.10 and 8.40 per cent per annum, respectively, the Dow Jones and the S&P 500 posted returns of 18.60 and 17.90 per cent, respectively. That explains why 70 per cent of muni-bonds are actually held by individual investors in the US.

If they account for even one-hundredth of the proportion of the US debt market that they represent, the Indian muni-bonds market could touch Rs 3,200 crore. The demand from borrowers? According to the estimates of the National Institute of Urban Studies, the collective funds requirement for urban infrastructure projects in the 73 towns in India that have municipal corporations stands at Rs 40,000 crore--only.

However, before the muni-bond can even be a serious option, several gaps will have to be plugged. No financial information flows from municipalities into the financial markets today. And their accounting and reporting systems are so shoddy that they do not even begin to look like serious financial statements. Says a senior official of SBI Capital Markets, Bangalore, which lead-managed the Bangalore Municipal Corporation's muni-bonds issue: "Investors must first buy into the credibility of the municipalities."

Small as its beginning may be, the muni-bond will kick off a virtuous cycle in the use of public finance. As they seek funds on a commercial basis, urban municipalities will rely less on tax-payers' funds, scooped out of the reluctant coffers of state and central governments. In the process, they will have access to more funds, enabling greater development of the kind of infrastructure that makes for better conditions of living, larger markets, and stronger industrial activity. Because they will have to service these funds, the municipalities will gain in terms of efficiency and productivity, leading to all-round improvements in performance. Pricing of services will become more rational, and the collection-to-billings ratio will rise above the 40 per cent-mark they are languishing at.

Of course, before that can happen, the money-hungry municipalities will have to get their financing strategies right. By managing their muni-bonds smartly. Predicts Shreekant Javalgekar, 43, President, Lazard Creditcapital, the Mumbai-based merchant banking firm which has bagged the mandate for their bonds from all the 5 municipalities in Maharashtra: "With a good credit-rating and an attractive structure, muni-bonds can become popular debt instruments for all kinds of investors."

The structuring

Given the width of choice for the debt-investor, there must be something special about muni-bonds if they are to compete against more conventional instruments. That's where structure comes in.

The money for servicing General Obligation (GO) Bonds comes from the entire range of the revenue-raising activities of the municipality. By contrast, Revenue Bonds are issued to bankroll specific projects, which are the font of the resources used to service investors. Thus, the projects have to be money-spinners: a water-supply plan, for instance, which users will pay for.

If history is a guide, financing municipalities begins with go Bonds--as they did in the US till the 1970s--but then switches to Revenue Bonds, which have reversed the trend to account for 70 per cent of the US muni-bonds market. That's the likely pattern in India too since most municipalities are yet to grow the competencies required to execute a project on commercial lines, with a pricing strategy that can not only pay for the capital, but also turn in profits.

That's why, in the first phase, municipalities have no choice but to dip into their general revenues stream to service their debt. Concludes Mohan Nagarajan, 37, Chief Economist, Credit Analysis & Research, which has rated the Nashik and Pune municipalities: "Since the credit-worthiness of the municipalities will depend on their financial position, most of them have to issue go Bonds." But borrowers will be better-served by Revenue Bonds.

For starters, the very act of issuing bonds for a particular project will raise local awareness about the service, improving its chances of being more viable. And that, in turn, will raise the receptivity of other investors, especially local citizens, to the issue. Agrees K. Ramchand, 44, Vice-President, Infrastructure Leasing & Financial Services: "Revenue Bonds for a specific project can have an emotive appeal to locals, which can help sell the issue."

Second, the specific projects meant to be bankrolled with the bonds can be managed--in terms of finance, expenditure, cash-flow, surplus, evaluation, and rating--more efficiently than the chaotic manner in which the rest of the municipality is likely to be run. Remarks V.K. Bansal, 46, President, J.M. Financial & Investment Consultancy: "The viability of a municipal project can be worked out just like any corporate project. And this can ensure investor confidence in such bonds."

The market

It is virtually impossible for a municipality to go to the top of the credit-ratings; the best they can expect, probably, is A. In fact, the offerings of both the Ahmedabad Municipal Corporation and the Bangalore Municipal Corporation were given ratings of A (so--Structured Obligation) by CRISIL, which is described as a "high degree of certainty regarding timely payment of financial obligations." The implication: a higher rate of post-tax returns than the fixed deposit rates (11 per cent) of the banks.

In addition, the tax-breaks offered by Budget 99 on earnings from muni-bonds issued for financing infrastructure development, coupled with the lowering of deposit-rates following the cut in the Bank Rate by the Reserve Bank of India, mean that the actual coupon-rates can be lower than before.

Thus, the Bangalore Municipal Corporation bonds had to offer 13.25 per cent per annum--with a standby guarantee from the state government--while the Ahmedabad Municipal Corporation had to do better with 14 per cent. But the changed situation will now make even a 11 per cent coupon-rate a competitive option. Says Devendra Makwana, 47, Deputy Commissioner (Finance), Ahmedabad Municipal Corporation: "The infrastructure status granted to muni-bonds will help municipalities raise money through tax-free bonds at a cost of between 11.50 and 12.50 per cent."

If they offer these rates, municipalities could find many takers for their bonds. Provident funds, commercial and state co-operative banks, mutual funds, and insurance companies will be interested. After all, since muni-bonds qualify as public sector bonds, privately-owned provident funds, superannuation funds, and gratuity funds can invest upto 30 per cent of their incremental deposits in these instruments. Corporates too will divert their investments into muni-bonds to cash in on the tax-breaks.

There's one good reason to keep the placement a private one: securing a minimum of 90 per cent subscription to a public issue, as stipulated by the Securities & Exchange Board of India, will not be easy. Warns Bansal: "These are a new concept, and investor-awareness is low. So, it is possible that, at the retail level, they will not get the required response." It's not for the opportunity to trade that investors will put their money into muni-bonds. To ensure easy exit, municipalities are considering issuing bonds with put and call options so that both the issuer and the investor have the option of early redemption.

The Safeguards

Corporates have reputation, track-records, and knowledgeable analysts to tell investors just how credit-worthy they are. Municipalities have only the general impression that no city administration can ever be a profitable enterprise. Using a formal credit-enhancement measure can go a long way in convincing the investor that his cash is safe. One way is to create an escrow account in a bank, where the revenues from an identified stream--like parking-lot collections--are deposited regularly. This will assure investors that the municipality can, indeed, pay him back.

Both the Ahmedabad Municipal Corporation and the Bangalore Municipal Corporation have done just that. The Ahmedabad Municipal Corporation channels its octroi earnings--Rs 243 crore in 1997-98--into its escrow account, with a target of maintaining at least 1.50 times as much as it needs to service its bonds. As for the Bangalore Municipal Corporation, which does not have any octroi income, its escrow account is fed by its general revenues.

A second alternative is to set up a debt-service reserve fund, which offers a counter-guarantee to the investor. The process: getting the state government to provide a guarantee for the bonds. In 1998, the Karnataka government provided a guarantee for the Bangalore Municipal Corporation's muni-bond issue.

It's more than the management of municipalities that the advent of the muni-bond will change. Its could also induce a structural shift in the debt market once the muni-bond becomes a destination of money seeking a safe haven. To be sure, India's municipalities have a long way to go before they can establish themselves as able custodians of income-seeking investors. But once the more efficient urban administrations prove themselves capable of the task, the business corporation may, suddenly, find itself competing for cash with the municipal corporation.

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