By Kaylene Alvarez, Athena Global Founder and CEO
So, what is a bond then? In many ways it’s similar to a loan that you or I might get from a bank, or from our Uncle Harry. According to Investopedia, a bond is a: “fixed income investment in which an investor loans money to an entity (typically corporate or governmental) which borrows the funds for a defined period of time at a variable or fixed interest rate”. Instead of going to a bank for a loan, bonds can be issued by companies, municipalities, states, and sovereign governments to raise money and finance a variety of projects and activities. For the issuer, it’s an IOU to whomever buys the bonds. Owners of bonds are debt holders, or creditors, of the issuer.
Now let’s take a look at the basics of how a bond works:
First, a bond is issued for a defined period of time. Once the bond is issued, the issuer pays interest to the bond holders (this interest payment is called a coupon payment) at predetermined payment periods. When the time period expires, the face value is repaid to the bond holders, which is usually the principal amount originally invested. Typically, bonds are considered “fixed income” financial instruments, meaning that they pay a predefined interest rate, so that the income that goes to the bondholder is “fixed.” Variable or floating interest rates are becoming much more common, especially in impact bonds (which we’ll discuss in another blog).
As an example, let’s say a city wants to build a new school. Instead of going to a bank for the funding, the city may issue a bond to raise the money. The price of the bond (coupon rate)—or how much the buyer will get above their principal investment—is based on various factors such as: the credit rating of the city, the bond term (longer term is usually a higher coupon since there is more uncertainty), other debt the city might have already issued (if the city has a lot of other bonds issued, one might start to question the city’s ability to repay this one), and other market conditions (if this bond is really popular, it could drive down the coupon rate).
In this case, we’ll say the bond is going to be used to fund a specific thing, building a school for girls, which also makes it easier to determine the amount of the bond to be issued. If it costs US$1 million to build the school, then that is a good target for the amount of the bond issuance. Additionally, since the city is the issuer and also the recipient of the funds, it makes things cleaner since the city has only one credit rating, and only one entity is using the funds for a specific purpose. In very simple terms, these are considerations that go into the pricing and structuring of the bond.
In summary, a bond is like a loan in that it has principal and interest payments to the buyer, over a fixed period of time. For social impact bonds (SIBs), things get a bit more challenging as the coupon rate needs to be determined with very few comparable transactions to benchmark against, and the structure of the bond must also incorporate how to measure the desired impact outcomes associated with bond. Additionally, measuring social impact in itself is a whole different animal, which we haven’t yet covered. We’ll dive into these topics in further detail in subsequent blogs. [See Catalytic Capital for Women’s Empowerment Part 2: The Size-Impact Paradigm.]