Municipal Bonds Now Covered Under SEBI's Expected Loss-Based Rating Framework

In a big step to boost infrastructure growth and strengthen the municipal bond market, SEBI (India's market regulator) is looking to introduce a new way of rating municipal bonds. It wants to use the Expected Loss (EL)-based rating scale, which gives investors a clearer picture of the risks involved when investing in local government debt.

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So, What's This EL-Based Rating All About?

Until now, credit ratings for bonds have mostly been based on how likely it is that someone will fail to repay the loan; this is called the Probability of Default (PD). But EL-based ratings go a step further. They don't just ask, "Will this bond default?" They also ask, "If it does, how bad will the loss be?"

This combination of "how likely" and "how much" gives investors a fuller sense of the risk they're taking. That's especially important for municipal bonds, which often fund complex infrastructure projects with different levels of risk.

SEBI's consultation paper (released on March 28, 2025) stresses how this new rating system could help highlight the actual recovery prospects of municipal bonds and what investors might get back if things go south. SEBI is also asking for public feedback on the proposal until April 18, 2025, showing that it wants everyone at the table before making big regulatory changes.

Why Is This Even Needed?

Municipal bonds are issued mainly by urban local bodies (ULBs), such as city corporations and town councils in India . These bodies use the collected funds to pay for essential services like water supply, public transport, and sanitation within their jurisdiction. These are long-term, high-cost projects, so having a detailed credit rating is crucial for investors and the associated municipalities.

With this move, SEBI wants to:

• Make credit risk ratings more transparent.
• Help investors understand how much they could lose.
• Improve how these bonds are priced in the market.

The bottom line? SEBI wants to make municipal bonds more appealing to investors by making the risks clearer and, ideally, more manageable.

Where Do Things Stand Right Now?

Despite years of government support and policy pushes, the municipal bond market is still small. Since 2017, municipal corporations have raised just ₹2,584 crore, not nearly enough to meet the country's growing urban infrastructure needs.

A big roadblock? Most civic bodies either don't have credit ratings or have ratings too low to attract major institutional investors. SEBI's Executive Director, Pramod Rao, pointed out that out of around 5,000 urban bodies, only 100 are rated, and only a few have a strong AA rating or higher. That's a severe bottleneck.

What Else Is SEBI Doing to Help?

SEBI isn't stopping with just new rating scales. It's rolling out a broader set of tools to build up the municipal bond market:

• Credit Enhancements: SEBI is encouraging the NaBFID (a government-backed infrastructure bank) to support municipal issuers with credit boosts. This could raise their ratings and make their bonds more attractive to investors looking for a fixed income option to park their money in.
• Tax Incentives: SEBI is also pushing for tax breaks on municipal bonds, which could make them even more enticing to investors, with plans to pitch this idea to the Finance Commission soon.
• Easier Trading and Liquidity: To facilitate buying and selling these bonds, SEBI is considering moving settlements to a central platform (ARCL). This could increase liquidity, making the market more active and reliable.

Looking Ahead: What This Could Mean

SEBI's proposal signals a more open and collaborative approach to regulation. By asking for public input, it shows that it wants a system that works for investors, municipal bodies, and credit agencies alike.

If these changes go through, it could be a turning point for India's municipal bond market. With better ratings, tax perks, and improved trading infrastructure, more cities could access the funds they need to build and grow. And for investors, it could mean more opportunities with a clearer sense of the risks involved.

The success of all this, though, will depend on teamwork. Regulators, municipalities, and financial institutions all have to pull in the same direction. So, if you're a stakeholder, now's a great time to speak up and help shape the future of urban financing in India.