What is Commodity-Backed Bond
A commodity-backed bond is a type of bond whose value is directly related to the price of a specified commodity. 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, both of which are set at the time of issue.
A commodity-backed bond, however, will experience fluctuations in value when the price of the specified commodity rises or falls. The bond’s issuer determines how the bond’s value will change with the price of the commodity. Some commodity-backed bonds gain or lose face value with the commodity’s price. For others, the interest rate changes.
These bonds are generally issued by the companies that produce the associated commodity. Some of the commodities that bonds may be linked to include oil, gold, and coal. Investors tend to purchase commodity-backed bonds as a form of speculation when they believe that the price of that commodity will rise.
BREAKING DOWN Commodity-Backed Bond
Commodity-backed bonds tend to be long-term bonds, maturing over the course of at least five years. In this way, commodity-backed bonds are frequently used to hedge against inflation. This is because most commodities can be expected to gain value over time. 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 stands to earn more when the commodity gains value. They also frequently have a call option, meaning that the issuer may call the bonds back for redemption at a specified time before they reach maturity. These qualities of commodity-backed bonds help protect the issuer from overly large payments to investors in the event that the commodity’s price goes up significantly.
Risk and commodity-backed bonds
Commodities can be quite volatile, which means that their prices can fluctuate a great deal. Thus, a commodity-backed bond carries a degree of risk for the investor. Regular bonds usually appeal to investors who want a predetermined yield with little to no risk. Commodity-backed bonds do not offer this. 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. There is the possibility, however, that a commodity-backed bond will generate a higher yield for the investor than a traditional bond, depending on the commodity and the market.