Bullion: What It Is, How It's Used, and Ways To Invest in It

What Is Bullion?

Bullion is gold and silver that is officially recognized as being at least 99.5% and 99.9% pure and is in the form of bars or ingots. Bullion is often kept as a reserve asset by governments and central banks.

To create bullion, gold first must be discovered by mining companies and removed from the earth in the form of gold ore, a combination of gold and mineralized rock. The gold is then extracted from the ore with the use of chemicals or extreme heat. The resulting pure bullion is also called "parted bullion." Bullion that contains more than one type of metal, is called "unparted bullion."

Understanding Bullion

Bullion can sometimes be considered legal tender, most often held in reserves by central banks or used by institutional investors to hedge against inflationary effects on their portfolios. Approximately 20% of mined gold is held by central banks worldwide. This gold is held as bullions in reserves, which the bank uses to settle international debt or stimulate the economy through gold lending. The central bank lends gold from their bullion reserves to bullion banks at a rate of approximately 1% to help raise money.

Bullion banks are involved in one activity or another in the precious metals markets. Some of these activities include clearing, risk management, hedging, trading, vaulting, and acting as intermediaries between lenders and borrowers. Nearly all bullion banks are members of the London Bullion Market Association (LBMA), an over-the-counter (OTC) market which offers little to no transparency in its dealings. OTC markets are dealer networks for financial products, commodities, and securities that don't trade on a centralized exchange.

The twelve LBMA market makers include banks such as:

• BNP Paribas
• Citibank
  
• Credit Suisse
• Goldman Sachs
• HSBC
• ICBC Standard Bank
• JP Morgan Chase
• Merrill Lynch
• Morgan Stanley
• TD Bank
• UBS
• Standard Chartered Bank

How Banks Lend and Sell Bullion

When a central bank lends gold to bullion banks for a specified period, say three months, it receives the cash equivalent of the gold lent to the bullion bank. The central bank lends this money on the market at a lease rate known as the Gold Forward Offered Rates (GOFO), which is published daily by the LBMA. The higher the lease rate, the more incentive a central bank has to lend gold from its reserves. The bullion banks who borrow the gold can sell the gold or lend it to mining companies.

If the bullion bank sells the gold on the spot market, it will receive cash for the transaction. The spot market is where bullion and other commodities are traded at the prevailing market rate. An increase in the supply of gold in the market reduces its price. The bullion bank hopes that by the time it’s scheduled to repurchase the gold from the spot market, the price of bullion will be lower so that the bank can buy it back at a lower price than it had originally sold it. At the end of the loan period, the bank buys back the gold and returns it to the central bank.

Bullion banks that lend gold to mining companies would usually do so to finance a project being run by the company. A mining firm would also borrow gold if it entered into a forward hedge contract in which gold, that has not yet been mined or extracted from the earth, is pre-sold to buyers. If some or all of its buyers expect a physical delivery of the gold bullion, the mining firm would opt to borrow the gold from the bank, which would subsequently be delivered to the buyers on the other end of the forward agreement. The gold lent to mining companies is usually repaid from the companies’ future mining output.

The Bullion Market

Bullion is traded in the bullion market, which is primarily an OTC market open 24 hours a day. Trade volume in the bullion market is high since it includes the vast majority of bullion trading prices throughout a given day. Most transactions are completed electronically or by phone. There are various bullion markets globally, including in London, New York, Tokyo, and Zurich. 

The price of gold bullion is influenced by demand from companies that use gold to make jewelry and other products. The price is also impacted by perceptions of the overall economy. For example, gold becomes more popular as an investment during times of economic instability.

Although gold tends to have greater demand, both gold and silver bullion are viewed by many investors as safe-haven investments. The safe-haven status usually leads to price increases during geopolitical events such as war, terrorist activity, and any instability that can lead to a conflict. Also, global financial issues such as a fear of a government default on debt or the financial collapse of a country lead to increased demand for bullion.

Rising prices or inflation in an economy tend to erode the return on investments. If an investor, for example, earned 4% on a bond and prices rose by 2%, the return on the bond investment was only 2% in real terms. If overall prices are rising, commodities tend to rise as well. As a result, gold and silver bullion are used to hedge investment portfolios against inflation.

Purchasing and Investing in Bullion

There are various ways to invest or own bullion. Please note that similar to any other investment, bullion prices can fluctuate, meaning there's a risk for loss. Below are a few of the popular ways that market participants invest in bullion.

Physical Form

An investor who wants to purchase precious metals can purchase it in physical bullion form or paper form. Gold or silver bars or coins can be purchased from a reputable dealer and kept in a safe deposit box at home, in a bank, or with a third-party depository. Also, you can purchase bullion in an allocated account at a bank which holds the bullion for the client. The client has full legal ownership of the gold. If the bank faces bankruptcy, its creditors have no claim to the bullion in the allocated account since it belongs to the client or owner, and not to the bank.

Exchange-Traded Funds (ETFs)

Although it's not equivalent to owning gold, investing in gold or silver through exchange-traded funds (ETFs) allows investors access to the bullion market. ETFs are funds that contain a collection of securities while the fund typically tracks an underlying index. With Gold or Silver ETFs, the underlying asset might be gold certificates or silver certificates, and not the physical bullion itself. Gold certificates can be exchanged for the physical gold or for the cash equivalent at a bullion bank. ETF funds can be bought and sold similar to equities using a standard brokerage account or an IRA brokerage account. ETFs typically have low fees and are easier for most investors to gain access to the bullion market instead of owning physical silver or gold outright.

Futures Contracts

Investors can also buy a bullion futures contract, which is an agreement to buy or sell an asset or commodity at a preset price with the contract settling at a specific date in the future. With gold and silver futures contracts, the seller is committing to deliver the gold to the buyer at the contract expiry date. Until the delivery happens, the buyer will not own the gold, and will only be an owner of a paper gold contract. However, if the buyer does not want to own gold bars or coins, the contract can be sold before the expiry date or the contract can be rolled forward into a new one.

It's important to note that futures trade in contracts–not shares–meaning they can easily cost $100,000 for one contract. As a result, brokers allow credit-worthy investors to borrow on margin, which is essentially a loan from the broker. Futures can be quite profitable given their large notional amounts, but can equally lead to significant losses if the bullion price moves adversely. Typically, futures are best suited for the most experienced investors.