The Successful Default: When a Municipal Bond Serviced Investors but Failed Citizens

Background: Understanding the Municipal Bond Default Case

One of the early success stories of municipal bond issuance in India was that of Pune Municipal Corporation (PMC) when it raised ₹200 crore in June 2017 for a 24×7 water supply project. The bond issue, which was oversubscribed six times, was hailed as a milestone in reviving the municipal bond market in the country. PMC also earned a five-year 2% interest subvention incentive from the Union Government linked to the bond issue.

Fast forward to the present – the bonds fall due for redemption in 2027. Throughout the 10-year issue period, PMC has complied with the requirements under the Securities and Exchange Board of India’s (SEBI) Issue and Listing of Municipal Debt Securities Regulations-2015 (ILMDS Regulations) and is all set to repay the bonds next fiscal. As things stand currently, there are no signs to indicate that the PMC will default on its bond redemption commitments.

Why Municipal Bonds Are Falling: Early Warning Signs in Public Finance

“Perfect!” one would say! “PMC is a role model for municipalities aiming to tap the municipal bond market to finance their development plans.” Except that there is a twist to the story. PMC’s bond journey is making the headlines for all the wrong reasons. Money raised has remained unutilised for nine years, since the water supply project for which the bonds were issued never took off. Going by media reports, land acquisition challenges and contracting issues are stated to be the underlying reasons for the non-starter. PMC now finds itself with the unenviable reputation of being the darling of investors and the bad boy of Pune citizens simultaneously.

Is Municipal Bond Safe for Investors? How Investor Interests Were Protected

The PMC case validates SEBI’s position as a guardian of investor interest. Adherence to the ILMDS Regulations has ensured that bond proceeds have remained ringfenced from general funds of PMC throughout the nine years and are available to repay bondholders. PMC has been regular in servicing half-yearly interest payments. It continues to be credit-rated AA+ (Stable). Parking of bond proceeds in fixed deposits pending utilisation – a requirement under the ILDMS Regulations – has ensured that PMC earned interest on idle funds which contributed to bond interest-servicing. Furthermore, if the 2% interest subvention incentive from the Union Government is also factored, the fiscal impact on the finances of PMC – with an annual budget size of approximately ₹15,000 crore – would be marginal.

When Citizens Pay the Price: How Public Interest Was Compromised

“Financial masterstroke” – you would say? Agreed. But what about public interest, which seems to have taken a beating on multiple counts. Citizens are yet to see the water supply infrastructure that the bond was supposed to fund. The Union Government’s interest subsidy incentive will now enrich bondholders without producing anything tangible for Pune city. In addition to interest paid on the bonds, related expenses in the form of bond issue expenses, project initiation costs, legal and professional fees, and bond servicing have drained public money. A rough calculation puts the aggregate cost – to PMC and the Union Government combined – at above ₹50 crore over the issue period. Of this, net interest

expense itself exceeds ₹40 crore on account of the bullet redemption at the end of ten years.

Would the exception become the norm for Municipal Bonds?

Clearly, the ILMDS Regulations have taken care of investor interest; but the same cannot be said of the larger public interest. In the backdrop of PMC’s case, one can already hear noises about: (i) how bonds are not the ideal financing instruments for the municipal sector, (ii) how abysmally low absorptive and spending capacities at municipalities would mean that PMC’s case is only the beginning of a series of such events as the government and market players try to accelerate municipal bond issuances, and (iii) how PMC is the exception and it should not come as a surprise if other municipalities with weaker fiscal management discover – when the time to repay bondholders comes – that they have used up the bond proceeds for other pressing needs.

What Can Be Done to Make Municipal Bonds Safer for All Stakeholders?

Land acquisition and contracting issues are long known to be the bane of public sector infrastructure projects in India. It is common to find instances of delayed or stalled projects in government at all levels. Whether funded out of own funds, grants, or borrowed money, the financial repercussions of stalled projects can be substantial. However, that does not justify a shift away from debt financing to a conservative approach of only using budgetary sources or grants to finance urban growth. On the contrary, the focus should be on mitigating risks of project failure through better planning, best-in-class procurement and contract management practices, better monitoring, and effective dispute resolution mechanisms, while continuing to exploit market sources of financing. In parallel, the focus should also be on mechanisms to reduce the financial impact of project failures should they occur. SEBI has recently (May 2026) issued a consultative paper proposing significant changes to the ILDMS Regulations to boost municipal bond issuances. While the proposed changes address the demand side, this article discusses five complementary design improvements to mitigate risks arising from poor absorptive capacity of money raised on municipal bonds.

1– Project readiness criteria

The ILMDS Regulations currently mandate approvals to be in place for projects to be eligible for bond issuance. Additionally, mandating minimum readiness criteria can help

Net interest cost computed by the author assuming a differential of 2 percent between interest payable on bonds over interest earned on fixed deposits. Interest subvention incentive has not been considered since that is met from public money.

reduce uncertainties associated with project commencement as well as timely completion and improve the chances of utilisation of capital raised. Specific readiness criteria can be prescribed for different types of municipal projects. Examples of readiness criteria include land availability of 80% and above, environmental clearances, power and water availability, construction readiness certificates, and proof of commitment of the issuer’s contribution (counterpart funding).

For setting readiness criteria for municipal bond-funded projects, one can look at the National Highways Authority of India (NHAI)’s Infrastructure Investment Trust (InvIT) model of monetising only assets that are operational and generating toll revenue.

2– Project substitution mechanism

In addition to project(s) directly covered in a bond issue, allowing issuers to include – in the offer document – a supplementary list of pre-screened projects matching the risk-return profile of the main project(s) could be useful. In the eventuality that one or more of the main projects does not take off for various reasons, the issuer may be allowed to use the bond proceeds for projects on the ‘supplementary list,’ subject to approvals. Currently a “change in the use of proceeds” requires a special resolution by 75% of the investors, which issuers find difficult to organise. The proposed project substitution mechanism, coupled with necessary guardrails, can help in faster redeployment of unutilised bond funds by the issuer.

3– Tranche-based “just-in-time” funding

The ILMDS Regulations currently allow multiple tranches of fund raises using a Shelf Offer Document up to one year from the opening of the first tranche. Expanding the window to two years can help issuers plan drawdowns closer to the requirement of funds commensurate to project progress, thus avoiding parking of bond proceeds in bank deposits for long periods. Further, the Shelf Offer route can be made mandatory for projects with lower levels of readiness along with a ceiling on the first tranche amount. Such design elements can help prevent over-ambitious drawdowns and avoidable interest payments, thereby reducing the overall cost of funds raised. This feature assumes even more important in the current scenario where the Union Government is trying to encourage large issuances more than ₹1,000 crore.

Entities like Power Finance Corporation use the “Shelf Prospectus and Tranche Prospectus” facility effectively to align fund raises to availability and readiness of investible projects.

4– Outcome-linked incentives

The current scheme of incentives for municipal bonds under the Atal Mission for Rejuvenation and Urban Transformation (AMRUT) scheme (₹13 crore for every ₹100 crore raised) and the new incentive scheme announced in the 2026 Union budget (₹100 crore for individual issuances above ₹1,000 crore) are offered as bullet incentives on successful listing of bonds. Linking incentives to milestones such as project technical readiness, commencement, completion, and satisfactory bond servicing can ensure that the issuer has “skin in the game” throughout the bond lifecycle.

Staggering of incentives is an inherent feature of the Production-linked Incentive (PLI) Scheme of the Union Government.

The following idea is inspired from SEBI’s frameworks for Green Debt Securities and Environment, Social, and Governance Debt Securities (GDS and ESGDS Frameworks). These Frameworks cover green bonds, social bonds, sustainability bonds, and sustainability-linked bonds and are more recent compared to ILMDS Regulations.

5– Early redemption for purpose washing

The ILMDS Regulations currently require an issuer to submit a half-yearly report on the status of implementation of projects financed from bond proceeds, along with reasons for delays if any. However, no consequences are prescribed for chronic delays. SEBI’s GDS and ESGDS Frameworks provide for early-redemption triggers if the issuer is found “purpose-washing,” i.e., using the proceeds for non-ESG objectives. A provision can be introduced in the ILMDS Regulations on similar lines, under which, non-utilisation of bond proceeds beyond a specified period triggers early redemption. Early redemption can be a powerful deterrent for issuers sitting on idle borrowed funds for lengthy periods or those engaging in “purpose-washing” tactics.

For example, the Production Linked Incentive Scheme ‘National Programme on High Efficiency Solar PV

Are Municipal Bonds a Good Investment? Key Takeaways for Investors and Policymakers

India’s urban sector is expected to witness massive investments in the coming years. Bonds hold immense potential in channeling market-based finance towards municipal investments. Although PMC’s is an isolated case, more such incidents can erode investor faith in municipal bonds and prove counter-productive to the Government’s and SEBI’s efforts to improve their uptake. PMC’s case provides valuable feedback on the design, governing mechanism, and real-life usage of municipal bonds. Imbibing such lessons into product features early on would ensure that municipal bonds serve not just investor interests but also produce tangible outcomes for urban dwellers.

Author: Ashok Rao, Executive Director – Management and Governance Consulting

References :

PMC to return unused ₹200 crore municipal bond funds to investors – msn – https://www.msn.com/en-in/money/markets/pmc-to-return-unused-200-cr-municipal-bond-funds-to-investors/ar-AA1Yrbma?apiversion=v2&domshim=1&noservercache=1&noservertelemetry=1&batchservertelemetry=1&renderwebcomponents=1&wcseo=1

When municipal bonds fund nothing – Ms. Astha Agarwalla – Basic is Beautiful – https://basicisbeautiful.substack.com/p/when-municipal-bonds-fund-nothing?r=7fpof&utm_campaign=post&utm_m=

Consultation Paper on review of the ILDMS Regulations – SEBI – May 2026 – https://www.sebi.gov.in/reports-and-statistics/reports/may-2026/consultation-paper-on-review-of-the-sebi-issue-and-listing-of-municipal-debt-securities-regulations-2015-_101404.html

National Highways Infrastructure Trust investor presentation – February 2026 – https://nhit.co.in/pdf/investor-presentations/22%20February%202025%20Investor%20Presentation_NHIT.pdf

Power Finance Corporation – Shelf Prospectus for Public Issue of Bonds – https://www.pfcindia.co.in/ensite/Home/VS/10304

Municipal Bonds need more than incentives to fund India’s cities [Commentary] – Dr. Ravikant Joshi – Mongabay India – https://india.mongabay.com/2026/03/municipal-bonds-need-more-than-incentives-to-fund-indias-cities-commentary/

Modules’ of the Ministry of New and Renewable Energy (MNRE), Government of India – https://cdnbbsr.s3waas.gov.in/s3716e1b8c6cd17b771da77391355749f3/uploads/2023/08/2023080898.pdf

Chapter IX-A of SEBI’s Master Circular for issue and listing of Non-convertible Securities, Securitised Debt Instruments, Security Receipts, Municipal Debt Securities and Commercial Paper – https://www.sebi.gov.in/legal/master-circulars/may-2024/master-circular-for-issue-and-listing-of-non-convertible-securities-securitised-debt-instruments-security-receipts-municipal-debt-securities-and-commercial-paper_83546.html

[1] PMC to return unused ₹200 crore municipal bond funds to investors – msn – https://www.msn.com/en-in/money/markets/pmc-to-return-unused-200-cr-municipal-bond-funds-to-investors/ar-AA1Yrbma?apiversion=v2&domshim=1&noservercache=1&noservertelemetry=1&batchservertelemetry=1&renderwebcomponents=1&wcseo=1

[1] When municipal bonds fund nothing – Ms. Astha Agarwalla – Basic is Beautiful – https://basicisbeautiful.substack.com/p/when-municipal-bonds-fund-nothing?r=7fpof&utm_campaign=post&utm_m=

[1] Net interest cost computed by the author assuming a differential of 2 percent between interest payable on bonds over interest earned on fixed deposits. Interest subvention incentive has not been considered since that is met from public money.

[1] Consultation Paper on review of the ILDMS Regulations – SEBI – May 2026 – https://www.sebi.gov.in/reports-and-statistics/reports/may-2026/consultation-paper-on-review-of-the-sebi-issue-and-listing-of-municipal-debt-securities-regulations-2015-_101404.html

[1] National Highways Infrastructure Trust investor presentation – February 2026 – https://nhit.co.in/pdf/investor-presentations/22%20February%202025%20Investor%20Presentation_NHIT.pdf

[1] Power Finance Corporation – Shelf Prospectus for Public Issue of Bonds – https://www.pfcindia.co.in/ensite/Home/VS/10304

[1] Municipal Bonds need more than incentives to fund India’s cities [Commentary] – Dr. Ravikant Joshi – Mongabay India – https://india.mongabay.com/2026/03/municipal-bonds-need-more-than-incentives-to-fund-indias-cities-commentary/

[1] For example, the Production Linked Incentive Scheme ‘National Programme on High Efficiency Solar PV

Modules’ of the Ministry of New and Renewable Energy (MNRE), Government of India – https://cdnbbsr.s3waas.gov.in/s3716e1b8c6cd17b771da77391355749f3/uploads/2023/08/2023080898.pdf

[1] Chapter IX-A of SEBI’s Master Circular for issue and listing of Non-convertible Securities, Securitised Debt Instruments, Security Receipts, Municipal Debt Securities and Commercial Paper – https://www.sebi.gov.in/legal/master-circulars/may-2024/master-circular-for-issue-and-listing-of-non-convertible-securities-securitised-debt-instruments-security-receipts-municipal-debt-securities-and-commercial-paper_83546.html