From: Issue 1
Can Bond Markets Save the World?
The first in a series looking into how better designed bond markets can deliver outcomes that are both virtuous and profitable.
What keeps a president up at night? Is it the spectre of calamitous scenarios, such as climate change or bursting prisons, long after his or her presidential library is built? No, nothing makes presidents or CEOs quake in their boots quite like the wrath of bond markets. That’s because bond markets have the power to cut off oxygen. When bond markets are unhappy, they hit where it hurts in the form of higher interest payments on debt. The knock-on effects can suffocate the economy of an entire country, as Greece has recently learned. Bond markets pass verdicts that cannot be ignored.
For many, the power of bond markets to dictate the behaviour of presidents is yet one more example of how Wall Street greed trumps Main Street needs. Ironically, bond markets are probably the most powerful tool for harnessing the power of capital markets to align outcomes that are both virtuous and profitable. The $82-trillion bond market doesn’t just alert us to long-term risks that we can no longer ignore; it has the promise to force and enable us to confront those risks. Greece wouldn’t and couldn’t balance its books if it didn’t have a gun to its head and some fresh cash.
This is not a new idea. It was the bond markets turning off the taps that brought South Africa’s apartheid regime to an end as much as it was the will of the people. In the 19th century, bond markets paid for the European sewers that stopped cholera, and Victory Bonds enabled the defeat of the Nazis.
Where things get really interesting is when we design bonds that deliver superior returns by addressing existential threats to our industrial economy. This can be done with a kicker (a bonus in addition to the standard bond coupon) linked to long-term public goods paid for by unlocked accretive cash flows.
Climate bonds can build a new clean-energy infrastructure, and social impact bonds can save us money on prisons. Even traffic congestion can be solved with a well-designed bond. What would a good design look like? The key is for the bond issue to present a clear win-win for both the issuer and the buyer. To ensure incentives are aligned, there must be a fair split, where the cost of providing the kicker is sensible in relation to the value created by achieving the quantitative eco-social goal.
Keeping people in jail is expensive. Tried and tested programs, such as recreation centres in low-income areas, reduce crime and welfare rates. Former British Conservative Party Leader Iain Duncan Smith cites that for every $1 invested annually in proven prevention programs, society benefits by between $7.60 and $9.20. However, governments don’t have that dollar to invest. Social impact bonds, designed to have a kicker linked to successful specified cost reductions, would align the interests of bondholders with lower crime rates and less strain on the public purse.
Traffic congestion hits productivity hard. Bond markets love productivity growth but hate government deficits. The rub hit in Ontario (plagued by $6 billion of productivity lost each year to gridlock) when proposed public spending on transit was kiboshed by a bond syndicate that didn’t like rising government debt. As far as bond markets are concerned, a dollar is a dollar whether it’s invested in productivity enhancing transit infrastructure or thrown down a sinkhole. A Transit bond with a kicker linked to productivity gains would go a long way to satisfying the syndicate.
Climate change is the ultimate market failure. The costs of inaction aren’t meted out for decades, yet the price of action hits the pocketbook today. The solution is renewable energy and a grid to get it to market. Unlike fossil fuel plants, the majority of the costs for clean energy is the cost of debt capital. This conundrum is compounded by capital markets’ aversion to financing new technologies (never mind if they are proven) at low-interest rates: solar projects borrow at 15 per cent, coal borrows at 5 per cent. A triple-A, government-backed green bond, with a kicker tied to future carbon prices, would significantly reduce borrowing costs for projects that deliver energy security today and mitigate climate risk far into the future.