Municipal bonds get a new rating framework: What expected loss ratings mean for investors

The Securities and Exchange Board of India (SEBI) has introduced a new rating framework for municipal bonds by allowing credit rating agencies (CRAs) to assign Expected Loss (EL) ratings alongside the existing standardised probability of default (PD) rating scale, according to its Annual Report 2025-26. The move is aimed at providing a more comprehensive assessment of municipal bond issuances, particularly those issued to finance infrastructure projects.

The regulator said the decision was driven by the need for a more detailed evaluation of municipal bonds, which are typically project-based instruments used to fund urban infrastructure and civic development. While conventional credit ratings assess the likelihood that an issuer may default on its repayment obligations, SEBI said Expected Loss ratings can better capture the recovery prospects associated with such projects.

Expected Loss ratings

According to the report, SEBI determined that Expected Loss ratings could provide investors with additional information beyond the existing standardised rating framework. These ratings are intended to reflect the expected recovery value of project-based municipal bonds if a default were to occur, thereby offering a broader perspective on the credit risk associated with such issuances.

To facilitate this, the regulator has permitted credit rating agencies to extend the Expected Loss-based rating scale to municipal bonds while continuing to use the existing probability of default rating scale. As a result, municipal bond issuers can now be assessed under both frameworks.

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How the new framework differs

The report distinguishes the new framework from the conventional approach by noting that the existing standardised ratings primarily indicate the probability of default. In contrast, Expected Loss ratings incorporate recovery prospects into the assessment, making them particularly relevant for infrastructure-linked municipal bond issuances.

SEBI has not replaced the existing rating methodology. Instead, it has allowed Expected Loss ratings to be used in addition to the standardised rating scale, enabling investors to access another measure while evaluating municipal bond offerings.

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Part of broader credit rating reforms

The municipal bond initiative forms part of SEBI's broader policy measures during 2025-26 to strengthen India's credit rating ecosystem. The annual report states that the regulator's initiatives focused on improving ease of doing business, refining rating methodologies and enhancing disclosure standards to promote greater transparency and standardisation across the industry.

SEBI noted that credit rating agencies play a critical role in reducing information asymmetry between issuers and investors by simplifying complex credit profiles into standardised ratings. The regulator said these ratings support efficient capital allocation and more accurate pricing of credit risk across the financial system. The introduction of Expected Loss ratings for municipal bonds is intended to further strengthen this framework by providing a more comprehensive assessment of project-based debt instruments.

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