Capital markets: How to build a social bond market

By: Keith Mullin

Social bonds are in vogue in debt capital markets. And why shouldn’t they be? Improving the access of under-served target populations to basic goods and services, to social betterment and health is a laudable aim. And one that should raise the perceived value of banks and institutional investors in the eyes of the communities they serve. The urgency of the environmental theme, invigorated by COP21 climate change commitments, has deflected the attention of policymakers from the issue of funding social needs in the capital markets. For the burgeoning social and sustainability bond market, that is not necessarily a bad thing. Market participants can – and should – use the cover of environmental focus to build the robust underpinnings the market needs if it is reach its ambitious goals.

Killing off already audible allegations of social-washing will be essential. That puts the impact assessment piece front-and-centre of the agenda. For a host of compelling reasons, the emerging social bond (SB) market should look to social impact bonds (SIB), also known as the payment-by-results or pay-for-success model, for specific answers to this issue.

Social use-of-proceeds bonds pre-date green bonds. The International Finance Facility for Immunisation’s (IFFIm) $1 billion debut offering to fund GAVI Alliance’s child vaccination programme came eight months before the first green bond (the European Investment Bank’s inaugural climate awareness bond) and celebrated its 10th anniversary in July 2017.

But good data is hard to come by. KM Capital Markets research puts gross issuance of social and sustainable bonds at just shy of $14.3 billion in the first seven months this year, with a slight volume advantage in favour of social. That is equivalent to 20% of the green bond market for the same period. Since that debut IFFIm trade, there has been some $52.5 billion of social/sustainable volume.

Just as in green finance, the benefits to issuers of using the social label are clear. Japan International Cooperation Agency (Jica) saw an immediate difference after it categorized its domestic FILP agency bonds as social in 2016. Jica made its social debut in September 2016 (a ¥35 billion ($320 million) dual-trancher), with follow-ups in February and June 2017 for a combined ¥25 billion; ¥20 billion more is scheduled for September 2017.

“Our investor base broadened due to the issuance of social bonds,” says Satoko Tanaka, a director in Jica’s capital markets division. “As the only Japanese issuer of social bonds in our domestic market, we saw a number of investors with ESG [environmental, social and governance] mandates selectively invest in our bonds. To advertise their ESG commitments, some investors have disclosed the purchase of our bonds on their websites or annual reports. We hadn’t experienced that before.”

Jica has not designated its global bonds as social, yet, even though the issuing framework is exactly the same and proceeds are earmarked for eligible projects under the Japanese government’s Development Cooperation Charter, which is aligned with the UN’s 2030 Agenda for Sustainable Development. But that may change, particularly if its offshore funding needs increase.

The IFC, too, noted some striking results following its inaugural $500 million three-year social bond in March 2017. The extensive preparatory work the funding team put in paid off. Almost a quarter of the order book came from investors new to IFC, a good result and a boon for pricing.

 

Unsurprisingly, the social and sustainability bond market has emerged as a predominantly public finance play. Few private entities have tapped the market; private-sector issuance will likely be episodic as the market builds.

Starbucks has been the stand-out corporate so far, with two corporate sustainability issues (a ¥85 billion seven-year in March 2017, preceded by a $500 million 10-year in May 2016) targeting sustainable coffee supply-chain programmes. The only other corporates to have ventured into the public labelled market are Grupo Rotoplas, the Mexican water storage company, in June 2017; Swedish property company Hemsö in 2016; and industrial gas company Air Liquide back in October 2012.

The financial institutions sector has seen a little more activity. State-run Banco del Estado de Chile has been the stand-out FIG issuer, selling one issue of microfinance bonds and a trio of women bonds under its Crece Mujer Emprendadora programme for proceeds of around $420 million equivalent, all Japan-targeted.

Elsewhere, French banking group BPCE sold a ¥58.1 billion preferred senior social samurai in June 2017 to refinance loans in the education, healthcare and social sectors; it followed up with a $50 million private placement of healthcare bonds in July placed solely with Nippon Life. Beyond that, Rabobank has done agri bonds; Lloyds Bank has sold Help Britain Prosper ESG bonds; while Turkish bank TSKB sold its debut sustainability bond in May 2016 with a tier-2 sustainable follow-up in March 2017. There has also been a smattering of sustainable covered bonds.

The gender theme (originally championed by IFC’s ‘banking on women’ bonds) could gather momentum with private issuers. In March 2017, for example, National Australia Bank (NAB) sold A$500 million ($395 million) of gender equality bonds to finance organizations cited by the Workplace Gender Equality Agency as Employers of Choice for Gender Equality.

Playing on the links between diversity and better business profits, the bank screened out companies whose primary activity included alcohol, gambling, tobacco, military weapons, predatory lending, fossil fuels, palm oil, transport of live cattle or whaling. “Gender equality is one of many big issues in society that business, banks and investors can do their part to address,” says Cathryn Carver, member of the executive leadership team, corporate and institutional banking, at NAB.

“We wanted to use our capital markets capabilities to create a product that would create a new pathway for big investors to back the Australian workplaces that are taking a leadership role to support women and equality. This was about providing choice and transparency to investors about where their money was used.”

Enthusiasm for social and sustainable bonds is palpable yet restrained. The big buyers to date have been in Japan. KM Capital Markets estimates that Japan-targeted issuance accounts for around 35% of gross volumes.

The first Japan-targeted offering – a R1.7 billion ($129 million) IFFIm trade in 2008 – stemmed from discussions between Daiwa and the World Bank. Since then, with IFFIm continuing to sell uridashi bonds, first the IFC, then the Asian Development Bank, African Development Bank, EBRD, Inter-American Development Bank and, more recently, CAF came in to tap the retail sector with an array of thematic bonds.

Can demand for the product spread?

“This product could be bigger than green bonds, given the vast array of eligible projects,” says Denise Odaro, co-chair of the International Capital Market Association’s (Icma) Green Bond Principles (GBP) executive committee Social Bonds Working Group (SBWG) and head of bond investor relations at the IFC, an early adopter of social themed bonds.

“As eligible use of proceeds criteria span multiple sectors, it is arguable that the product has a wider group of issuers that could come to market than green. It’s early days, but there is good potential for growth as investor demand for ESG bond product rises,” she says.

There is widespread agreement on this, particularly from bankers.

“I’m optimistic about the development of the social bond sector and expect to see an acceleration of issuance in the coming years,” says Pierre Blandin, global head of SSA DCM at Crédit Agricole CIB. “Bear in mind that a huge part of a government’s budget is social, so you might have a sovereign wanting to target a specific social issue that can be easily identified and supported with a social bond. The social bond market can catch up to green, but we need to be patient.”

Others, however, add notes of caution to their enthusiasm.

“The social bond market is here to stay and will be an important part of the dialogue with issuers,” says Vince Purton, head of debt capital markets at Daiwa in Europe, who worked on the initial IFFIm trade. “There are a good number of issuers who cannot do green but can do social; it’s as easy for social/sustainability issuers to find social assets to finance as it is for green/sustainability issuers to accumulate green projects. But monitoring, verification and standardization will complicate things massively because there are so many themes you cannot have a single tool to monitor them all.”

It is a point echoed by Mike Baird, chief customer officer, corporate and institutional banking, at NAB: “Institutional investors are starting to take social bonds more seriously. They increasingly want choices and options to act on social issues. While there are challenges facing market participants, such as improving our understanding of impact measurement frameworks, the willingness is there and momentum will come.”

The debate about social versus financial return has raged ever since use-of-proceeds bonds emerged over a decade ago. Generalist and ESG/SRI (socially responsible investment) bond investors alike are adamant that they should not to give up financial returns for social benefits.

That misses the point of ESG investing and grates with ESG/SRI bond fund managers.

“We’re not philanthropic, we’re an investment fund with an ethical screen and aim to deliver both financial and social returns,” says Bryn Jones, head of fixed-income at Rathbone Investment Management and manager of the UK fund manager’s ethical bond fund.

The fund, which launched at £12 million ($15.4 million) in 2002, breached the £800 million barrier in July 2017 and there is some anticipation that it will become the world’s first £1 billion ethical bond fund.

“Sustainability of income is key, especially in the bond market where you have asymmetric returns,” says Jones. “Your upside is yield and, if you’re lucky, some alpha generation from buying off the curve. But your downside is the same as equity, so you have to protect your clients’ downsides. That’s a large reason we have excellent risk adjusted returns.”

As if to drive home the point, Jones’s fund has achieved best-in-class risk-adjusted returns, to the point where clients without ethical mandates have gravitated towards it.

So what challenges do social bonds face? There are many.

Getting a grip on this slightly amorphous market is difficult: social and sustainable bonds have come to market using over 30 different names. Some clearly address environmental themes (water bonds, clean energy bonds). Many have social, SRI, ESG, sustainable or sustainability in the title. Others use nomenclature around specific themes (affordable housing, health, microfinance, poverty reduction, women etc.).

The latest iteration of the Social Bond Principles has taken a stab at defining themes. As the market grows, issuers should be discouraged from creative self-labelling in favour of a more formal categorization matrix. Similarly, use-of-proceeds descriptions will need to conform to minimum standards.

The market is also too segmented. It is as an assortment of de-linked segments, covering everything from the themed use-of-proceeds debt capital market; elements of the US muni market (which finance affordable housing programmes); the listed and unlisted charity bond sector (growing in the UK in particular); to the small, dynamic and rapidly growing SIB market.

Institutional market participants get very exercised about comparisons between social bonds and social impact bonds. Their emotional reaction is misplaced. True, from a technical standpoint SIBs are not bonds providing fixed cashflows and are more akin to principal-at-risk equity-type investments. But that misses the point. As the Social Bonds Working Group’s focus shifts to impact assessment, building a SB/SIB nexus could be a winning collaboration.

Aligning the market sub-segments under a continuum of mutual awareness and understanding, sharing best-practice and exchanging innovative ideas can only benefit issuers, investors and, ultimately, beneficiaries.

Beyond that, impact measurement is the most vital challenge the social bond market faces. There are some tough critics who will need convincing. “We reserve judgment on bonds with sustainability-earmarked proceeds,” says Thomas Bjørn Jensen, member of the responsible investment committee at money manager Sparinvest and co-manager of high-yield strategies (including the €240 million Ethical High-Yield Value Bond Fund). “Based on our experience with green bonds, we feel that the nascent [social] market lacks some of the basic features required to make it attractive for investors. We need to see far more issuance to provide critical mass. But most importantly, we need issuance to be properly risk-assessed well into the future. We like to rely on academic evidence demonstrating that investment strategies are sustainable and that positive results can be repeated over future economic cycles.”

That is the challenge the social bond market faces. Investors will demand to know what impact their investments are having. There remains an enormous amount of work to be done in this area and it will not be easy.

“The end-game for green bonds is avoiding and coming up with intensity measures around carbon emissions; there is no universal metric in the social space,” acknowledges Tanguy Claquin, head of sustainable finance at Crédit Agricole-CIB, the other SBWG co-chair.

Claquin believes, reasonably, that defining impact metrics is beyond the remit of capital markets practitioners. “Our responsibility is to make sure instrument integrity is preserved around transparency and accountability; that we say what we do and do what we say so investors and stakeholders can make informed choices. Finding a baseline against which you measure impact will be difficult.”

Finding that much-vaunted baseline was a recurring theme in Euromoney’s interviews. The IFC’s Odaro, acknowledging that setting performance indicators will be a challenge, also uses the baseline analogy. She believes that impact reporting will evolve through a series of incremental steps.

“If you look at where we were with green bonds,” she says, “we didn’t have a harmonized framework three or so years ago, so we can apply our experience from creating impact-reporting templates for green bonds. The SBWG intends to work on impact reporting with the aim of establishing key indicators that could be used in a harmonized reporting framework for social bonds.”

David Hutchison, CEO of non-profit Social Finance, adds: “To work out where the baseline is you have to ask questions like: ‘What would have happened if you hadn’t been there?’ Measuring improvement against a baseline looks complicated from the outside, but it’s an inevitable part of money changing hands on the back of an outcome delivered. What causes the greatest complication is ensuring that the person paying for outcomes pays for the value the project delivers. Investors want to be clear that if their investment delivers a benefit, they’re properly rewarded.”

Alex Goodenough, investment director of Big Society Capital (BSC), the not-for-profit social lender and investor-cum-fund-of-funds manager that has made available almost £1 billion of capital to charities and social enterprises over the last five years, is clear about what he wants: “One of our key requirements is a clear up-front impact thesis that defines exactly what the organization borrowing the money wants to achieve, the metrics aligned against it and the commitment to maintaining an impact-reporting stream throughout the life of the investment.”

The former DCM banker adds: “It’s important to ensure you have real alignment of intent and a pathway before you go into a programme. And you have to ensure you have the structures and governance to reduce any likelihood of gaming or creaming behaviour.”

Help regarding impact evaluation is at hand from social impact bonds. Over 100 SIBs are now live, with dozens more in process in around two dozen countries around the world. That tells its own story. Some $350 million has already been raised up-front to kick-start projects, and there is probably around $100 million more in the pipeline. Around one third, typically small and highly localized, are in the UK. Bigger-scale projects have emerged in the US and Australia.

One clear benefit of cross-fertilizing the SIB knowledge base for the benefit of social bonds is a canon of structuring experience and data. The institutional social bond market can learn valuable lessons about impact assessment tools and methodologies that it can overlay on the skeletal social bond principles. Testing for how impact might correlate to risk at the institutional level could also be a useful exercise.

Icma’s GBP executive committee upgraded the SBP in June but did not even acknowledge the tightly knit social finance ecosystem. This is odd.

“We’ve been putting social principles into practice on every deal we do,” says Dan Hird, head of corporate finance at Triodos Bank. “What we and people like us have been doing offers real examples of how this is working from the ground up and how we’re applying those principles.”

The green bond principles have, in fairness, helped foster a general understanding of the difference between green and other bonds in terms of transparency, accountability and the types of projects financed and they enjoy support across the industry.

“It’s good to have the Icma stamp,” says CA-CIB’s Blandin. “Investors have already completed the exercise once for green bonds, so they will digest the SBP much more quickly.”

It is a point echoed by Sophie Caillebotte, executive director of DCM at Daiwa Capital Markets Europe, who coordinates the firm’s SRI origination platform.

“We shouldn’t make life too difficult,” she says. “Social bonds need their own branding but they also need to maintain the connection with green, which is why the GBP ExCom kept the same governance framework for items such as reporting and external reviews, but separated the green and social principles to avoid diluting the social brand.

“Some issuers have and will issue both types, so the principles can’t be too divergent. By the same token, issuers like Council of Europe Development Bank or ICO didn’t want to issue under the green label. Social issuers need a voice, so we need to extend the social branding. Having a clear separation will help investors make proper choices.”

SIBs offer predominantly socially motivated capital access to projects on a highly localized but, more to the point, deeply granular results-driven basis. SIB commissioners, delivery partners, project advisers, arrangers, financiers and evaluation agents have spent an inordinate amount of time creating a framework for private engagement. Well-structured SIBs have eliminated or at worst minimized perverse incentives for profit-motivated capital. Coming up with creative ways to privately fund the provision of social care to vulnerable segments of society may appear to be poles apart from the narrative in institutional social DCM circles, but there are clear affinities. First, a focus on underserved/vulnerable target populations and, second, a thematic crossover: social bonds and social impact bonds have both tackled health, education, housing, employment, training and entrepreneurship.

For Hutchison at Social Finance, money is a powerful piece of the equation but it is not the core driver.

“What is exciting is creating an environment where all the delivery partners are focused as a team on delivering a set of outcomes rather than being rewarded for activities they carry out or working solely towards payment triggers,” he says.

In the debate that has emerged around calibrating trade-offs between social and financial returns, the SIB market is where the rubber hits the road.

“We’re exploring new ways of tackling entrenched social problems, establishing models that are sustainable and scalable,” says Hutchison. “We spend lots of time understanding issues, how money flows around a social problem and how it might be better deployed so organizations have the space to do what they do best and deliver better outcomes, while making sure they’re properly rewarded in the process.”

Since few SIBs have come to fruition, performance data is spotty. But the emerging picture is positive. In July, the independent evaluator published its final report into the world’s first social impact bond, arranged by Social Finance. The report determined that the £5 million intervention tackling recidivism among young offenders in Peterborough in the UK had cut re-offending rates by 9%, exceeding the government’s 7.5% target. That triggered repayments to 17 impact investors equivalent to an annual return of a little over 3%.

Not all deals work. The first US SIB, the Adolescent Behavioral Learning Experience (ABLE) Program at Rikers Island, was closed early as the evidence-based cognitive behavioural therapy used in the intervention failed to produce results.

Goldman Sachs had funded the project with a $7.2 million loan to social policy research organization MDRC, which was responsible for project implementation and overseeing the service providers. Goldman’s exposure was reduced by a $6 million Bloomberg Philanthropies grant, so the bank ended up losing $1.2 million. On the plus side, taxpayers did not spend a cent, while the data and insights collected during the project created value for all parties.

Goldman was undeterred by the experience. Following the Rikers Island project, it invested in several more impact bonds: the $25 million Rock Creek Environmental Impact Bond; the $18 million Massachusetts Juvenile Justice for Success recidivism project; and two children’s projects: Child-Parent Center in Chicago ($16.9 million) and Salt Lake County ($7 million).

The Salt Lake project, which focused on special education services, successfully triggered early payments. Savings to local government, expected to run into the millions over the life of the project, were $281,550 in year one. Of that, 95% went back to Goldman and co-funder the JB Pritzker Foundation.

Beyond impact assessment, other currents are inexorably driving the social bond and social impact bond markets closer together. Long the domain of social enterprises and foundations, banks and institutional investors are getting more active in SIBs.

Whether it is Bank of America Merrill Lynch acting as placement agent for Social Finance’s Massachusetts Pathways to Economic Advancement SIB; institutional investor participation in Social Ventures Australia’s Newpin and Resolve Social Benefit Bonds; NAB funding two-thirds of the On TRACC Finance SIB; UBS funding SIBs in South Korea, Israel and India; Goldman Sachs, Axa, Morgan Stanley and others establishing social impact funds; or the UNDP Social Impact Fund attracting banks and capital market investors, the institutional market is taking notice. The €100 million first-close of French social impact fund Hémisphère in June is taking the SIB concept into a new dimension. Managed by units of Caisse des Dépôts real-estate subsidiary and social housing specialist SNI Group, the fund is backed by Aviva, BNP Paribas, Caisse des Dépôts, CNP Assurances, MAIF and Groupe Pro BTP.

It will focus on placing people in permanent accommodation and finding emergency housing for migrants, refugees, asylum-seekers and the homeless. With the proceeds of a €100 million Council of Europe Development Bank loan, the fund will acquire around 60 low-cost hotels throughout France to build accommodation capacity. While the French government hopes to achieve a 40% cost saving on emergency overnight stays in private hotels, investor remuneration is tied to targeted outcomes.

“There’s a lot of money allocated to social impact funds, and SIBs are emerging as a really attractive investment opportunity,” says Hutchison. “We’ve generally found strong demand for the size of transaction we’re looking to fund, but I always have a weather eye on institutional money because if we want to take this market to scale, we need to find a way to building the confidence of that capital.”

A challenge for SIBs is making it easier, through structural innovation, for institutional money to put pay-for-success models into parts of their portfolio that can take that sort of risk. A big part of this nascent industry is about demonstrating a track record of delivery. As the early SIBs start coming to fruition, performance data has been very encouraging: risk-adjusted returns are in the 5% to 7% range.

In Hird’s view, the idea of mainstream financially incentivized institutional capital funding social services is not a short-term achievable goal but he is nonetheless optimistic: “If we can learn the right lessons, build trust, understand what makes an easily commissionable social bond and what the returns ought to be, iron out any perverse incentives in deal structures, the market should be able to scale in the future.”

Perhaps the biggest opportunity to drive a step-change in social finance stems from the fact that the issuer base for social bonds and the commissioning base for social impact bonds are converging on the same place: local authorities. In a world where central government is encouraging locally sourced solutions to social issues, but where municipal budgets are being squeezed, the benefits of results-dependent, taxpayer-neutral, innovative private-capital engagement with social issues are particularly clear.

Supranationals were early players in the social bond market, creating around two-dozen use-of-proceeds programmes across a range of themes. But their importance has waned over the years. Still heavily dominated by public finance borrowers, the centre of gravity of the social/sustainable bond market has shifted to agencies and local authorities.

Since 2015, the quantum of local authority issuance has been around three times that of supranationals, which have accounted for only 20% of volumes.

“Just like what supranationals did in the green bond space, they have paved the way for others to issue social and sustainability bonds,” says CA-CIB’s Claquin.

Hird at Triodos recognizes a similar direction of travel: “With central government having sustained the market to-date, the baton should pass to local authorities to start commissioning local services on a payment-by-results basis through social impact bonds.”

He acknowledges that local authority commissioners can be resistant to outside capital coming into what used to be publicly funded services: “Where the market is today, is trying to get them comfortable with the idea of having socially motivated outside capital come in, not just with money, but with innovative modes of intervention around entrenched social problems where existing public intervention may not have worked.”