In the modern era of constant innovation, the innovation often far outpaces the education and dissemination of information to relevant populations. The field of social impact investing is no different. As with any investment, the investor should adequately be educated and conduct their own due diligence before investing in any financial product. With this in mind we seek to assist in creating a heightened awareness concerning the benefits and potential risks between Social Impact Bonds (SIBs) and comparable investments.
First, we must answer the question, "what is a bond?" A bond involves issuing capital from a creditor to a borrower, with the borrower providing the creditor with an IOU in return, promising to make payments in the future. Many investors are attracted to bonds because they provide fixed and more predictable income streams. Investors in bonds range from individuals to insurance companies and pension funds.
The largest issuers of bonds are the U.S. Treasury, who issues roughly $11 Trillion in bonds annually. The next largest issuer of bonds are Corporations, who issue $8.5 Trillion in bonds annually. Municipal Bonds come in third issuing $2.5 Trillion. While, the emerging market for Social Impact Bonds since 2012 has averaged a modest $26 Million dollars respectively.
U.S. Treasury Bonds
The first type of bond we will discuss is the most widely known type, U.S. Treasury Bonds.These bonds are most often acquired by hedge funds, mutual funds, and large endowments. These bonds are attractive to investors because they are less risky than other bond types, with bonds guaranteed by the full faith and credit of the U.S. Government. Treasury Bonds also provide fixed and predictable income streams with interest payments often being paid to investors on a semi-annual or annual basis. Also, Treasury Bonds are liquid and can be traded amongst investors. Furthermore, Treasury Bonds are also tax-exempt at the state level, although not at the Federal level. However, there are a few drawbacks to the types of financial vehicles. Treasury Bonds are subject to and not adjusted for inflation, and investors assume the risk that their dollar invested today will not have a decreased value upon bond maturity. Additionally, Fluctuations in the interest rates affect the amount of semi-annual and annual interest payments to investors. Finally, while less risky, profitability tends to be lower as a result. According to Bloomberg, the 10-year yield for U.S. Treasury Bonds has been a modest 2.24%.
Another bond type of the Corporate Bond. Corporate Bonds are less liquid, have a higher default rate, and are not guaranteed. As a result, these investments are riskier than U.S. Treasury Bonds. On the other hand, with increased risk lies opportunities for higher profit yields than those traditionally associated with government backed securities. For example, investors who purchased Apples 30-year bond will be paid an annual interest rate of 3.45%, beating similar yields among U.S. Treasury Bonds. The shortfall is that they are not tax-exempt. The marginal tax rate for 2013 from income earners between $72,500 to $146,400 was 25%.
Municipal Bonds are issued by State and local governments, School Districts, and non-profits. These bond types have historically low default rates, making them less risky of an investment. However, certain municipalities have indeed defaulted in the past, such as Jefferson County, AL, Harrisburg, PA, Vallejo, CA, and Stockton, CA. There is also no Federal income tax for Municipal Bonds, making them attractive for many individual investors. The flip-side is that Municipal Bonds are not as liquid or as default-proof as U.S. Treasury Bonds, and with yields that are most often lower than Corporate Bonds. The S & P Dow Jones Indices has 3-year New York Municipal Bonds yielding 2.46%
Micro-Social Impact Bonds
Social Impact Bonds are relatively new to the market, and Micro-Social Impact Bonds are even more contemporary. These investment vehicles are optimized for the areas of Education, Health Care, Affordable Housing, Juvenile Justice, and Environmental Initiatives. These investments are closer to Corporate Bonds, in that they are not guaranteed by any government entity. These are purely private transactions that are guaranteed by Philanthropic organizations instead of government, making them attractive to investors because of their private nature. Also, investors stand to make a predictable 5% standard interest on their investment at a flat rate, or compounded semi-annually/annually, depending upon the preference of investors. Additionally, upon maturity investors are paid back on a per-capita basis, meaning that for every individual that successfully meets targeted outcomes, investors receive a payment. This mitigates risk for investors by making ensuring that even if the program implemented on the ground fails to meet benchmarks (i.e., 79 students vs. 80 out of 100 students graduating), investors are still paid for each outcome that was successful. There are also many tax-incentives, such as the New Market Tax-credits and Low-income Housing Tax Credits. The down-side to these investment is the obvious risk of the unproven market and reliance on service providers to perform and achieve outcomes. There is also the lack of liquidity and risk of philanthropic organizations defaulting, similar to a Corporate Bond.
The investment arena can be one of many hurdles and frustrations for those who are unfamiliar with the financial jargon and complex equations. We hope to bring a sense of clarity for those seeking to understand the differentiation between such investment vehicles. Please share your stories and experiences utilizing different similar investments, and if we can ever be of service please do not hesitate to contact us.
Ean Garrett, J.D., is the author of two books, "Rebirth of a Dream" and "The Immovable Race", as well as the Chief Innovation Officer of the consulting firm, Infinite 8 Institute, L3C, specializing in the design and finance of social impact systems. Follow him on Twitter & IG: @eangarrett