Make a Portfolio Impact With Social Impact Bonds

One of the major sticking points for ESG remains the fact that the sector is still considered “the Wild West” of finance. Thanks to its popularity, many managers have stuck an ESG label on older funds to try and drive up assets, while indices designed to track ESG scores often include less than desirable sectors like fossil fuels and defense. All of this has led various pundits to support the notion of greenwashing, while confusion reigns supreme among investors.

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However, there is one solution that seems to overcome these greenwashing ideals and strives to achieve the core of ESG’s main idea – implementing change for the better. Enter the humble social impact bond or SIBs.

SIBs are a unique funding vehicle designed to help state and local governments tackle certain social or green problems in their communities. Often governments will realize an issue but lack the funding to accurately tackle the problem. By tapping into the private sector, the project can get funded, the issue gets resolved and investors receive a handsome return.

The key to SIBs is that they are project-based, e.g., funding a prison rehabilitation program or reducing pollution in a local river. Private investors put up the capital needed to fund the project. How they are paid back principal and interest is by the project needing to meet a series of quantifiable metrics. If the project succeeds, investors get a good return. If the project fails to meet all the objectives, it’s a wash.

According to think-tank Brookings, and as of April 2023, there are more than 244 SIBs and development impact bonds (DIBs) outstanding. These bonds cross a variety of sectors, including social welfare, healthcare, education, employment and environmental needs. And more continue to get launched from both governments and nonprofits. For example, the World Bank just issued a $50 million emission reduction-linked bond to help finance a water purification project, while the Nature Conservancy issued a $50 million bond to protect 30% of Barbados’ marine area.

SIBs offer investors an interesting set of returns and the ability to increase their philosophy at the same time.

Despite being project-based, returns for social impact bonds can be quite high. Brookings again has some data on this: of the 50 social impact bonds issued to completion ending in 2020, the vast bulk of them met their objectives and paid investors, with returns as high as 20%. The very first SIB issued in 2010 – the U.K.’s HM Prison Peterborough One Services bond, which looked at rehabilitation rates – managed to pay investors a 3% return annually for seven years. Not too shabby considering this was the era of low to negative rates in Europe. Meanwhile, only two failed to do so.

Another reason to consider SIBs comes down to taxes. Many SIBs issued by state and local governments/agencies are considered munis and qualify for tax-free status.

Finally, SIBs allow investors to align their portfolios with their values and participate in philanthropy. Because they are project-tied, investors can see their “gifts” in action and engage in real change. And because results are reported, they can see that change occurring over time. Having a donation simply go into a charity’s endowment or main fund doesn’t have the same sort of effect as directly participating in a clean water project or community garden.

Perhaps the only issue with SIBs is getting your hands on them. Social impact bonds aren’t traded … just yet. The market is still too small. So, it’s very much still “buy & hold.” And unless you have a private banker at Goldman Sachs, getting the opportunity to participate in initial offerings is a no-go either.

But there are some fixed-income funds that have started to include SIBs and DIBs as part of their exposures. For example, both the TIAA-CREF Core Impact Bond Fund (TSBIX) and TIAA-CREF Green Bond Fund (TGROX) include SIBs as part of their mandates. TSBIX has about 40% of its portfolio in social impact bonds. However, not all mutual funds or ETFs with the word “impact” in their name will feature SIBs. There are plenty of other ESG-focused bonds out there that may have a social component, but only SIBs are outcome-based. Investors need to do their due diligence with regards to fund exposure.

Needless to say, the market for social impact bonds is starting to take off and it will only be a matter of time before investors everywhere are able to participate through active and indexed vehicles. For investors looking to do good and get a positive return, this is wonderful news.

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