Municipal bonds and the promise of urban reform

India’s cities need an estimated Rs 63 lakh crore in urban infrastructure investments between 2021 and 2036 (World Bank, 2022). To finance these needs, urban local governments (ULGs) continue to rely predominantly on central and state budgetary transfers, with limited contribution from their own-source revenues.

Bridging this gap requires ULGs to adopt debt financing instruments such as municipal bonds. The Atal Mission for Rejuvenation and Urban Transformation (AMRUT) set the early momentum, while the new Urban Challenge Fund links grants to a city’s ability to mobilise financing, fostering a credit culture (financial discipline and commitment to full and timely repayments) across ULGs. Forty-five metropolitan cities (with million-plus populations) that have stronger institutions, higher revenues, and greater economic dynamism are best positioned to lead this shift. FY 21-22 data from cityfinance.in shows these cities can potentially borrow about Rs 87,000 crore, yet less than 20% of this (Rs 18,000 crore) has been tapped so far.

Nearly all past issuances have come from these cities, accounting for under 10% of municipal borrowings. This underscores both their underutilisation and their potential as scalable debt instruments. After years of limited activity, the municipal bond market is gathering momentum. During the first ten months of FY 2025-26, twelve cities raised Rs 1,556 crore, marking the highest mobilisation by value and volume in nearly three decades.

Why do municipal bonds matter? They offer cities access to long-tenor, fixed-rate capital, often priced between concessional loans from multilaterals or state-level entities and commercial lending for creditworthy municipalities. Recent issuances demonstrate competitive pricing, with coupon rates ranging from 7.65% to 8.5%. These instruments shift reliance away from government guarantees to a city’s revenue base, strengthening accountability for project execution and debt repayment. Compliance with SEBI’s disclosure and reporting requirements institutionalises improvements in financial management and governance, strengthening city systems over time.

However, systemic gaps limit the deepening of municipal bond markets. First, the pipeline of creditworthy cities remains narrow. Regulatory norms and investor preferences favour highly rated bonds (AA- and above). Of the ~470 cities rated in 2017, only 164 received an investment-grade rating (BBB- and above). Yet, only 22 cities have accessed the market, raising Rs 4,340 crore through 30 issuances over the last decade.

Second, many cities are not yet capital market-ready. They must build a steady pipeline of bankable projects and strengthen institutional capacities for sound financial management, transparent and timely publication of accounts, and credible reporting on project execution to build market trust. Raising bonds requires professional expertise in financial structuring and post-issuance engagement – these are skills that remain scarce within city systems.

Limits of current incentives

Since 2017, AMRUT incentives have helped revive the municipal bonds market through interest subvention, reducing borrowing costs by up to 2.6% for medium-tenor bonds (around five years) and 1.3% for longer maturities (around ten years). However, most issuances remain anchored at Rs 200 crore, and the current design leans toward shorter tenors, missing the opportunity to attract long-term capital aligned with infrastructure lifecycles. After eight years, the incentive design needs a reset. The Rs-200 crore cap must be raised without expanding the incentive pool, linking it to revenue performance – with a portion released upfront and the remainder disbursed only upon measurable improvements in own-source revenues.

The Rs-100 crore incentive for a single Rs-1,000 crore issuance announced in the Union Budget 2026-27 seeks to encourage larger ticket-size issuances but is operationally viable only for the top ten metropolitan cities. For other cities, a pooled issuance could perhaps offer a pathway to tap this incentive.

Five measures can be adopted to strengthen the ecosystem. First, states and ULGs must prioritise improving their own revenue mobilisation, particularly through more rational pricing of urban services, to enhance creditworthiness and strengthen their debt-servicing capacity. A robust revenue foundation is critical for long-term sustainability.

Second, cities need credit-enhancement mechanisms such as upfront cash collateral and first-loss guarantee systems. Uttar Pradesh and Tamil Nadu have already improved ratings for nine cities, in total, through cash collateral mechanisms. The Reserve Bank of India (RBI)’s extension of partial credit enhancement (PCE) for municipal bonds, through its regulated entities (banks, NHB, NaBFID, HUDCO and IIFCL), addresses a long-standing market gap, which is expected to improve credit assessments and boost investor confidence.

Third, refinancing through bonds can lower borrowing costs, reduce interest rate volatility, and remove restrictive covenants, while giving cities access to longer-tenor capital that better aligns with infrastructure lifecycles. It can further support higher issuance volumes as the market deepens. SEBI may consider permitting refinancing through municipal bonds.

Fourth, state-level Urban Infrastructure Development and Finance Corporations (UIDFCs) should evolve into hubs for project preparation and financial structuring, with functional autonomy. Market finance divisions within the UIDFCs, staffed with experienced transaction advisors, can be strengthened to support cities in preparing bankable projects and meeting bond-related disclosure and compliance requirements.

Lastly, transparency in project execution and service delivery is essential to build market trust. Cities should publish project- and service-level data across the lifecycle to ensure clear trackability and credibility.

Financing alone is not enough. Municipal bonds can bridge key investment gaps, but only if revenues strengthen and transparency improves.

(The writer is a senior associate at Janaagraha)

Disclaimer: The views expressed above are the author's own. They do not necessarily reflect the views of DH.