Like it or not, when it comes to social impact bonds (SIBs), the perspective of many private sector investors is that there is still too much risk for too little potential payout. This sentiment has stifled socially impactful investments.
Many private sector actors like banks and bankers played a notable part in the 2008 financial crisis. At the same time, advanced financial engineering techniques such as credit default swaps (CDSs), credit ratings, and tranched debt issuances took a fair share of the blame. During the crisis, for instance, credit default swaps were linked to the downfall of the prominent US-based insurance provider AIG, while credit rating agencies often provided investment-grade ratings to dubious-quality assets. As someone who had worked in the derivatives side of the banking industry, I began to wonder whether we could change the underlying purpose these kinds of financial products—use them to convert greed to good—to improve the existing SIB model. Could we use similar advanced financial techniques to incentivize greater involvement from private sector social impact investors, and thus, provide a much-needed revenue source for future social projects?
I believe the answer is yes. By applying the following financial techniques to future SIBs, we can lower investment risk and spur investment from social impact investors into much-needed projects:
1. SIBs plus CDSs: The first financial feature for future SIB issuances could be the greater use of CDS products. CDSs essentially act as insurance policies in the event of certain predefined credit events, such as a failure to pay interest. In exchange for a CDS premium, the CDS provider assumes the risk of the CDS premium payer. This is similar to how a car insurance provider (CDS provider) assumes the risk of a car owner’s insurance premium payment (CDS payer). By using CDSs, the SIB issuer can outsource its credit risk (failure to pay, bankruptcy, or moratorium on owed obligations) to the CDS provider, and thus lower risk related to transaction funding. This benefits both the SIB issuer and the social impact investors.
2. SIBs plus credit ratings: The second financial feature for future SIB transactions could be greater use of credit ratings by SIB issuers. Credit ratings provide a market signal as to the quality of the particular asset. For instance, the “AAA” rating by Standard & Poor’s is considered the highest-quality marker, and thus, indicates the lowest-risk asset (almost like a student’s A+ course grade to potential employers). The subprime crisis showed that even the most reputable credit ratings agencies (Standard & Poor’s, Moody’s, and others) were far from perfect when certain highly rated assets defaulted. But overall, using credit ratings for certain SIB issuances would help increase transparency, lower risk, and thus lower the premium needed to incentivize social impact investors to buy SIBs in the marketplace.
3. SIBs plus tranched debt: Future SIB transactions could also utilize tranched issuances—or “slices” of the same bond, but with each slice reflecting different risk profiles and financial returns. For example, a SIB tranched debt paper issuance could have the following tranches and interest rate payouts (listed from least to most risky): senior tranche (X%), mezzanine tranche (X%+Y%), and equity tranche (X%+Y%+Z%). With a tranched social impact bond, if the SIB issuer were unable to pay owed interest to the social impact investor, then the equity tranche debt paper holders would take the first loss, followed by the mezzanine, and then senior tranches. Overall, tranched SIBs would expand the potential social impact investor base, because they offer a wider array of risk profiles (and thus, interest rates) in the same issuance. This would make social impact bonds appealing to a more diverse group of potential social investors.
4. SIBs plus retail mini-bonds: The fourth financial feature for future SIB transactions might be issuances to retail (individual) investors. Countries like the UK have already explored this. However, one challenge with issuances would be the added disclosure and registration requirements typically required for issuances to individual investors. In the future, we could imagine an online and/or peer-to-peer SIB exchange. But before we get there, SIB retail market issuances in the form of “mini-SIB bonds” could be a worthwhile endeavor, since they would foster greater individual investment interest in social impact bonds.
Any or all of these four financial features used with SIBs—CDSs, credit ratings, tranching, and retail mini-bonds—would transform today’s first-generation SIBs into next-generation SIBs. Since these features already exist and have been used for years outside the SIB marketplace, why not simply apply them to the SIB markets to improve philanthropic investments based on market principles—thus converting greed to good for both shareholders and stakeholder value worldwide.