CASE STUDIES IN BLENDED FINANCE FOR WATER AND SANITATION Pooled Municipal Bond Issuance in Tamil Nadu (India) August 2016 PAKISTAN BANGLADESH Summary Overview INDIA Location: Tamil Nadu, India, South Asia MYANMAR Approach to Blended Finance: The Water and Sanitation Pooled Fund (WSPF) in Tamil Nadu issued a pooled bond to facilitate access to long-term domes- tic capital markets for small and medium Urban Local Tamil Nadu Bodies (ULBs) to finance water and sanitation services. This enabled a grouping of 13 ULBs to overcome high SRI transaction costs and mobilize funds through a single LANKA bond issuance. Debt was repaid from project cash flows MALDIVES and from general ULB revenues. A multi-layered credit enhancement package was designed in order to extend the maturity of the bond and increase investor confi- dence. The different credit enhancement mechanisms included a debt service reserve fund capitalized by the IBRD 42434 | AUGUST 2016 state government, creation of individual ULB escrow accounts, a local debt service reserve fund, a State rev- partnership for the purpose of attracting private domestic enue intercept mechanism, and a partial credit guarantee financing for different types of infrastructure investment. from USAID. However, the TNUDF primarily serviced large ULBs with dependable revenues. Many of the small and medium sized municipalities tended to be excluded from access- Context ing financing via the TNUDF. Bond issuance fees, legal costs, and an inability to get a credit rating prevented In the 1990s and early 2000s, reforms in India helped small and intermediate local governments from access- create opportunities for financing capital infrastructure for ing capital markets. In addition, sanitation and water water and sanitation. Reform efforts included facilitation were among the most neglected areas of public infra- of private sector investment and increased autonomy structure provision. awarded to municipal governments, known as Urban Local Bodies (ULBs), in India. In parallel, growth in the To address these shortcomings, the State Government of local debt markets meant that local debt became an Tamil Nadu (GoTN) created a pooled entity the Water and attractive tool for reducing the financing gap in the sec- Sanitation Pooled Fund (WSPF). The WSPF functions as tor, particularly for ULBs. a special purpose vehicle to specifically help small urban local bodies finance their water and sanitation services In 1996, the State of Tamil Nadu, the World Bank, and by raising capital market resources on a pooled basis. USAID set up the Tamil Nadu Urban Development Fund (TNUDF). The Fund was established as a public-private Case Studies in Blended Finance for Water and Sanitation: Pooled Municipal Bond Issuance in Tamil Nadu (India) Financial Structure and Approach to out prior to the end of the bond lifespan. The ULBs Blended Finance paid back their WSPF debt obligations from project and municipal revenues, including water tariffs and from An early WSPF pooled bond issuance took place in interest earned on the money deposited from connec- 2002, to facilitate access to domestic capital markets for tion fees. 13 small and medium ULBs. The selected local bod- ies were mixed in terms of financial strength, but all had WSPF bonds were unsecured, but a multi-layered credit in common that they were unable to issue a municipal enhancement mechanism was put in place, which was bond on their own. The bonds were issued by WSPF, instrumental to the fund’s success. Figure 1 shows the and the proceeds were then lent back to the 13 local blended financial structure with credit enhancements. governments as sub-loans to finance their infrastructure projects. The state government of Tamil Nadu capitalized a debt service reserve fund (DSRF) with an amount close to The pooled bond issuance for the 13 municipalities and 1.5 times the annual principal and interest payments. town panchayats took the form of a structured debt obli- Approximately US$1.42 million was assigned to the gation for Rs. 304.1 (US$6.2 million). The bond was AA fund, and helped generate investor confidence through rated, and had a coupon of 9.2 percent per annum and the assurance that the fund could pay creditors if the a maturity of 15 years, with put and call options after ten municipal borrowers were unable to meet scheduled years. These options acted as a safeguard for investors repayments. by offering them the opportunity to take their money FIGURE 1  Pooled Municipal Bond Issuance in Tamil Nadu, India: Financial Structure Bond Holders - Private Institutional Investors Tamil Nadu State Government Capital from Bond Coupon Capitalized with Bond Issue Repayments Government Funding USAID / DCA Government Grant Water and Sanitation Partial Pooled Fund (WSPF) Credit Bond Issuer Debt Service Guarantee Reserve Fund Debt Services Revenue Intercept (if ULB cash ows are short) Legend Repayment Supply of Finance Accessed if escrow Repayment Flows Sub-loans account is not suf cient Escrow Local Debt Service Credit Enhancement Account Reserve Fund Public/Donor Agencies ULB Revenues / Project Cash Flows Private Financiers 13 Urban Local Bodies (ULBs) Financial Intermediary Service Provider ULBs ULBs ULBs ULBs ULBs 2 Water Global Practice Case Studies in Blended Finance for Water and Sanitation: Pooled Municipal Bond Issuance in Tamil Nadu (India) A second level of enhancement was created by legally Water Supply and Sewerage Project. As was the case for requiring the 13 participating local governments to estab- WSPF, a USAID partial credit guarantee for 50 percent of lish an escrow account and make deposits into it so that the principal was an important feature of the transaction. their annual debt service obligations to WSPF was paid in early. Municipal revenues from property tax and other tax collections, as well as project revenues, were the Lessons Learned source for funds deposited into this account. A third level The Tamil Nadu pooled fund demonstrated that of enhancement was added with a local debt service grouped financing vehicles can play a critical role in reserve fund, which received contributions amounting attracting repayable finance to small- and medium- to 5 percent of the principal amount borrowed by each sized water and sanitation service providers. ULB. That account could be tapped in the event that However, development of the structural components for revenues in the debt service escrow were not sufficient. setting up such entities is time and resource intensive, A fourth layer of enhancement included the ability of the which has undoubtedly contributed to the fact that few WSPF to intercept State revenue transfer payments. other such funds have been set up so far. Finally, a partial credit guarantee was provided by USAID A supportive environment for municipal finance facil- on the WSPF’s debt service reserve fund. The guarantee itated the use of effective credit enhancements in would help re-supply 50 percent of the principal amount the transaction, which lowered the risk for commer- of a default paid for by the debt service reserve fund cial financiers. Participating ULBs were legally required (DSRF). In that case USAID, would be reimbursed for its to establish an escrow account and there was a State guarantee payment by the GoTN, while all other funds revenue intercept mechanism. used from the DSRF would be reimbursed by deduct- ing moneys from the defaulting ULB’s individual State Credit enhancement mechanisms require explana- revenue transfer payments. tion, when they are new to a market. The first pooled transaction suffered from insufficient and inadequate marketing. Investors did not fully understand the trans- Results action and the guarantees provided, as the financing The WSPF helped spread credit risks and pool the ULBs’ mechanism was new to the market. Once properly resources to meet funding requirements for market explained, the bond sold well. Likewise, the revenue access, thereby achieving economies of scale in the intercept mechanism was used once for one of the process. The proceeds from the pooled bond issuance local borrowers because of a repayment problem. This were disbursed to ULBs in 2003, and the majority went proved that such a mechanism could work, but it took to refinance outstanding loans at lower interest rates for a long time for WSPF staff to implement, since it was previously completed water and sanitation projects. The the first time that such a mechanism was used, and it WSPF issuance for this initial bond set a model for future involved multiple governmental agency approvals. pooled bond use. It was well structured from a credit perspective and achieved a very high AA rating, which Sustainable issuance is important for longevity of enabled it to be sold. a pooled financing initiative. After the first issue, the WSPF did not issue another bond again for several In Tamil Nadu and Karnataka state, similarly structured years. Its CEO was hired by a development bank and bonds have since been issued. In Karnataka, a special the senior staff were heavily recruited to banks and rat- purpose entity, the Karnataka Water and Sanitation ing agencies, depleting its expertise and momentum. Pooled Fund Trust (KWSPF), was established in 2003. This lack of sustainable issuances created a lack of The KWSPF was intended to facilitate market access liquidity for the WSPF bonds, and risked making them for eight local governments. In 2005, it succeeded in more expensive. issuing a 15-year bond to support the Greater Bangalore www.worldbank.org/water 3 Case Studies in Blended Finance for Water and Sanitation: Pooled Municipal Bond Issuance in Tamil Nadu (India) References This case study is part of a series prepared by the World Bank’s Water Global Practice to highlight existing blended USAID. 2009. “Financial Sector Series #1: Enabling sub- sovereign bond issuances: Primer and Diagnostic finance experiences in the water sector. Checklist.” Washington, DC: USAID. http://pdf.usaid.gov/ pdf_docs/Pnadu683.pdf Blended finance refers to “the strategic use of develop- ment finance and philanthropic funds to mobilize private Fitch Ratings. 2003. Water and Sanitation Fund (WSPF). India capital flows to emerging and frontier markets,” as per the Public Finance Credit Analysis. New York, New York: Fitch OECD definition (WEF OECD, 2015). Concessional funds Ratings. can be used in a catalytic manner to open up new oppor- Kehew, R., T. Matsukawa, & J. Petersen. 2005. “Local tunities for commercial financing, by providing technical Financing for Sub-Sovereign Infrastructure in Developing assistance to borrowers and lenders to help them become Countries: Case Studies of Innovative Domestic Credit more familiar with each other, help structure transactions, Enhancement Entities and Techniques.” Discussion Paper provide credit enhancement mechanisms, etc. No. 1 Infrastructure, Economics and Finance Department. Washington, DC: World Bank. Private capital flows can help with meeting immediate Trémolet, S. 2010. Innovative Financing Mechanisms for the financing needs for investment in the water sector but Water Sector. OECD: Paris. ultimately need to be repaid. Repayable financing from USAID. 2003. “Pooled Finance Model for Water and Sanitation private sources to the water sector can come in vari- Projects: the Tamil Nadu.” FIRE(D) Project Note, No. 31. ous forms, including as commercial bank loans, bonds Washington, DC: USAID. http://pdf.usaid.gov/pdf docs/ or equity. To obtain such financing, water-sector actors PNACT334.pdf need to be able to repay the borrowed amounts and the WEF OECD. 2015. Blended Finance Vol. 1: A Primer for associated funding costs, which means that they need to Development Finance and Philanthropic Funders. Geneva: be deemed “creditworthy” by providers of finance. World Economic Forum. 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