Understanding Social Impact Bonds

By James Kerin AAA

A social impact bond (SIB) is a debt instrument that directly links its yield with a social outcome or series of outcomes. In technical jargon, the utility of the invested capital directly influences the return on the investment (ROI). Therefore, potential investors must evaluate the effectiveness of the proposed measures that are to be funded by their capital.

In contrast, the majority of debt instruments are contractual agreements that channel capital from a creditor to a debtor, while stipulating the terms by which the funds are to be returned. This could include the coupon rate, the term to maturity and/or the par value. Short of declaring bankruptcy, the indebted party is obligated to return the principal with interest to the creditor, regardless of the use the funds were put to.

Social impact bonds are not affected by interest rate risk, reinvestment risk or market risk. This stems from the fact that the bonds' ROI is wholly independent from fluctuations within the fixed income marketplace. However, much like all other bond classes, they are subject to default risk, event risk and inflation risk. Inflation, of course, is forever the scourge of bond-land, as it can eat away at the bondholder's real return.

The nature of a social impact bond is inherently risky. If the proposed outcomes are not achieved, the entirety of the social investor's capital is at risk.

SEE: Impact Investing: The Ethical Choice

Historical Examples

To date, social impact bonds have only been issued by the public sector for projects that increase infrastructural efficiency and decrease overhead. However, social impact bonds are unlimited in their potential and can be used by the private sector as well. They can essentially be used to achieve any quantifiable goal.

The first social impact bond was designed by the Government of the United Kingdom in March 2010. The problem was simple: at Peterborough prison in Cambridgeshire, England, 60% of short sentence prisoners re-offended within one year post release. To address this issue, the Ministry of Justice hatched a scheme that reduced the agency's risk of ineffectively using its resources. Five million pounds was raised to finance certain social sector organizations to provide interventions that are flexible to meet the needs of 3,000 male prisoners leaving the facility. A control group was created in order to assess the effectiveness of the intervention.

For the Ministry of Justice to offer a return on investment, the crime rate of ex-convicts must fall by 7.5% at the minimum. If the policies enacted surpass even that threshold, the bondholder's yield can reach up to 13%.

The Peterborough social impact bond does a fantastic job of aligning the incentives of the bond issuer and its creditors. The Government of the U.K., the issuer of the bond, has a responsibility to protect its citizens and to prudently maintain its budget. Issuing a social impact bond accomplishes just that, while eliminating the risk of wasting taxpayer pounds. If the project succeeds, the crime rate drops by 7.5% or more, a surely satisfactory outcome. Moreover, if the project fails, the social impact bondholders foot the bill.

SEE: 5 Basic Things To Know About Bonds

From the perspective of the bondholder, a social impact bond offers a desirable yield independent of market conditions with considerable upside. Provided that the interventions meet the defined threshold parameters, a 7.5% annualized rate of return is certainly a healthy starting point. Furthermore, if the investor resides in Peterborough, he has every incentive to make the area a safer place to live.

The Emergence of the Socially Conscientious Investor
Recent trending in the financial world has indicated that socially affiliated investment vehicles and funds are in higher demand than ever before. A large portion of the movement can certainly be attributed to disillusionment with business as usual on Wall Street, an extension of more stringent corporate regulation and business transparency. Financial innovation has a way of responding to demand for a certain investment product or framework - look no further than the growth of exchange traded funds (ETFs). Of course, not all financial innovations are made equal: toxic collateralized-debt obligations (CDOs) engineered the 2008 financial crisis.

The growth of socially responsible investing (SRI) is testament to more responsible investment trending as well. In 2010, socially responsible investing encompassed an estimated $3.07 trillion out of $25.2 trillion in the U.S. investment marketplace. The mission of the investment strategy is to allocate capital and resources to companies that conduct business in a sustainable and ethical manner. Paradoxically, a socially responsible investing strategy involves the rejection of the traditional "bottom line" business approach in order to generate a superior bottom line.

SEE: Go Green With Socially Responsible Investing

Challenges
Social impact bond offerings, while promising, face many challenges before joining all the other popular bonds in the playground. Bond underwriters may struggle with quantifying seemingly qualitative variables within the social impact debt contract. For example, how did the Ministry of Justice determine at what crime rate threshold they would distribute yield? A crime rate drop-off might be explained by sheer randomness within the sample population. Adverse selection may have also played a role in the relative effectiveness of the prisoner intervention. As criminal participation was non-mandatory, prisoners who were involved may have been more likely to recuperate, regardless of their taking part in the program or not.

In short, measuring outputs in the form of sheer data is relatively simple. Accurately measuring and identifying outcomes is far more elusive. When it comes to social impact bonds especially, there is no margin of error. While the market will discount the price of normal bonds as demand dictates, social impact bonds are not priced efficiently, as their value is contingent upon the utility of their underlying capital.

Before Social Impact bonds can realize their vast potential, underwriters must overcome investor skepticism in answering these questions.

The Bottom Line
Social impact bonds are a financial innovation in answer to increased demand for socially cognizant products. They are powerful investment vehicles for the solving of social issues in a sustainable fashion, both in the public and private sectors.

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