Commodity-Backed Bond

What Is a Commodity-Backed Bond?

A commodity-backed bond is a type of debt security where the coupon payments and/or principal is directly linked to the price of the underlying commodity.

Key Takeaways

  • Commodity-backed bonds are debt securities where the price of an underlying commodity directly influences the coupon payments and/or principal.
  • Not only can commodity-backed bonds provide bondholders with a steady source of income, but they can also be a profitable vehicle for investors who speculate that the price of the commodity will rise.
  • Because investors have the potential to earn more if the commodity gains value, commodity-backed bonds typically pay lower coupon rates than regular bonds.

Understanding Commodity-Backed Bonds

Most bonds have a fixed value determined at the time of purchase. This value is a combination of the bond’s face value and its interest rate (coupon), both of which are set at the time of issue. Commodity-backed bonds are issued where either the interest payments or the face value can vary with the price of the underlying commodity.

Therefore, a commodity-backed bond will experience fluctuations in value when the price of the underlying commodity rises or falls. The bond’s issuer determines how the bond’s value will change with the price of the commodity. For example, the issuer might tie a gold-backed bond's principal to $1,000 or the market price of one ounce of gold, whichever is higher at maturity.

Aside from providing the bondholder with a steady source of income, commodity-backed bonds have the added attraction of being a speculative vehicle for investors who believe that the price of the underlying commodity will rise. Additionally, commodity-backed bonds are frequently used to hedge against inflation.

Commodity-backed bonds tend to have maturities longer than five years. Classified as long-term liabilities, these bonds serve as important sources of financing to the companies that issue them. Commodity-backed bonds usually pay a lower coupon rate than regular bonds, since the investor has the potential to earn more if, or when, the commodity gains value.

Commodity-backed bonds are generally issued by the companies that produce the associated commodity. Examples include bonds linked to oil, gold, and coal. Furthermore, commodity-backed bonds usually have a call option associated, which allows the issuer to redeem the issue prior to maturity. This feature helps protect the issuer from overly large payments to investors in the event that the commodity’s price goes up significantly.

Commodity-Backed Bond Risk

Commodities can be quite volatile, which means that their prices can fluctuate a great deal. Thus, a commodity-backed bond generally carries a higher degree of risk for the investor than do regular bonds. Regular bonds usually appeal to investors who want a predetermined yield with little to no risk. Commodity-backed bonds do not offer this safety. Instead, they appeal to investors interested in speculating, who are willing to carry a degree of risk. In the event that the commodity loses value, the bondholder may see their bond’s coupon rate or face value fall, lessening their overall yield.